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Why Do Governments End Up With Debt? Short-Run Effects Matter


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.

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Article provided by Western Economic Association International in its journal Economic Inquiry.

Volume (Year): 50 (2012)
Issue (Month): 4 (October)
Pages: 905-919

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Handle: RePEc:bla:ecinqu:v:50:y:2012:i:4:p:905-919
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