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Matthias Doepke - Marcroeconomics - Chapter 14

Chapter 14 The Optimal Path of Government Debt Up to this point we have assumed that the government must pay for all its spending each period. In reality, governments issue debt so as to spread their costs across several periods, just like households do. | Chapter 14 The Optimal Path of Government Debt Up to this point we have assumed that the government must pay for all its spending each period. In reality governments issue debt so as to spread their costs across several periods just like households do. The path of governmental debt over time very often corresponds to events of major historical import such as wars. For example England has paid for her wars by issuing debt resulting in debt peaks during the Seven Years War the Napoleonic Wars and especially World War I. Indeed some economists argue that the sophistication of England s capital markets contributed to her eventual successes in the wars of the 17th and 18 th centuries. The U.S. and several European countries have run persistent peacetime deficits since about 1979. Quite a bit has been written in the popular press about the dire consequences of the ever-mounting debt. In this chapter we will not consider that a large debt may be inherently bad instead we will treat the debt as a tool for use by a benevolent government. In the previous two chapters we saw that government spending may crowd out consumption and investment and that government taxes may decrease labor supply and capital accumulation but in this chapter we will have nothing bad to say about debt. In Chapter 18 however we argue that under certain circumstances large and persistent government deficits may be inflationary. In this chapter we will continue to ignore the price level and the ability of the government to raise revenue by printing money so we will not be able to consider inflation directly. We will begin by considering the government budget deficit and defining some terms. The reader should be thoroughly familiar with the terms defined there as well as the historical paths of the debt deficits debt to GDP ratios and so on. Next we will consider a very simple theory of the debt that of Barro-Ricardo Equivalence. 154 The Optimal Path of Government Debt Barro-Ricardo Equivalence is named