Public Debt Adjustment in a Simple Model of Stochastic Endogenous Growth

In this paper, we propose a prototypal stochastic endogenous growth model to address the question of the channels through which public debts might affect potential growth and undermine total factor productivity. In an endogenous growth framework, transitory shocks and the way they are accommodated exert permanent effects on the level of variables in equilibrium (hysteresis). We study two adjustment strategies for the public finance stance in response to a rise of public debt generated by an adverse technological shock: a ?gradualist? strategy and a ?cold turkey? strategy. Our model shows that ?shock therapy? strategies, although most costly in the short-run, are better than gradualist? ones in the long-run. Therefore, assessing the relative benefits of the two alternative strategies on household welfare is a matter of parameter values in the utility function. Furthermore, the effect of technology shocks is strongly amplified by the adjustment mechanism of public debt, producing a procyclical amplification effect that we call ?public debt accelerator?.