WHY DO GOVERNMENTS END UP WITH DEBT? SHORT-RUN EFFECTS MATTER

Authors

  • AUDREY DESBONNET,

    1. Desbonnet: Assistant Professor, University Paris-Dauphine, LEDa, Place du Maréchal de Lattre de Tassigny, 75775 Paris Cedex 16, France. Phone +33 (0) 1 44 05 45 29, E-mail audrey.desbonnet@dauphine.fr
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  • THOMAS WEITZENBLUM

    1. Weitzenblum: Professor, University of Lille 2, EQUIPPE and CEPREMAP, Faculté des Sciences Juridiques, Politiques et Sociales, 1 place Déliot, 59000 Lille, France. Phone +33 (0) 3 20 90 75 35, E-mail thomas.weitzenblum@univ-lille2.fr
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    • We thank two anonymous referees for helpful comments as well as Daniel Cohen, Xavier Ragot and all participants at the PSE macroeconomic tea-break (2008), at the Journées Louis André Gérard-Varet (2008) and at the annual Public Economic Theory Conference (2009).


Abstract

This paper reconsiders the impact of public debt in an economy with heterogeneous households and incomplete markets to emphasize the short-run effects of an increase in public debt. As compared to models that rest on steady-state analysis, we show that the welfare gains of a public debt increase are substantially higher when transitional dynamics are accounted for. The additional debt issue allows for a temporary reduction in the income tax rate, which stimulates labor supply and generates an overshooting of the interest rate. The short-run gains create a temptation to deviate toward higher levels of debt. Debt increases continue to generate welfare gains even when debt is considerably higher than its long-run optimal level. (JEL E60, H60)

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