TWIN DEBT REDUCTION, GOVERNMENT POLICIES AND INTERDEPENDENCE

A two-country model with a portfolio choice between money and imperfectly substitutable domestic and foreign bonds, a floating exchange rate and perfect foresight is presented. Account is taken of capital accumulation, government debt and current account dynamics. Numerical methods, including extensive sensitivity analysis, are used to trace the results and spill over effects of a cut in government spending, aimed at the reduction of both external and government debt. This restrictive policy is conducted in a country with nominal wage rigidity, while the passive country is featured by real wage rigidity. The difference between lump sum and progressive income tax on the one hand and bond versus money financing of the budget deficit on the other, are analysed.