ENDOGENOUS GROWTH AND GOVERNMENT DEBT

The feasibility of the policy of perpetual debt financing, given a particular path for expenditures and taxation, has been questioned over the years. This paper considers the feasibility of perpetual debt financing in an economy where the growth rate of GNP is endogenously determined and is a function of debt levels. The model of endogenous growth presented here is a modified version of the one given in Prescott and Boyd. This particular model is chosen for two reasons. First, agents live for finite lengths of time; so Ricardian equivalence will not hold, in general, in this model. Also, the production function is linear in the capital stock; as will become clear below, this implies that the equilibrium paths of the state variables can be characterized as first order linear difference equations. Necessary and sufficient conditions for the feasibility of a policy of balancing current expenditures and taxation (and bond-financing deficits) are derived. One necessary condition is that labor's share of output must be greater than 2/3. Also, it is shown that the key condition for feasibility can be interpreted as a comparison between the long-run growth rate that would exist in the absence of debt and the real interest rate. -from Author