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When Does Government Debt Crowd Out Investment?

  • Shu-Chun S. Yang

    (International Monetary Fund)

  • Nora Traum

    (North Carolina State University)

We examine when government debt crowds out investment for the U.S. economy using an estimated New Keynesian model with a detailed fiscal specification. The estimation accounts for the interaction between monetary and fiscal policies. Whether private investment is crowded in or out in the short term depends on the fiscal or monetary shock that triggers a debt expansion: Higher debt can crowd in investment despite a higher real interest rate for a reduction in capital tax rates or an increase in productive government investment. Contrary to the conventional view of crowding out, no systematic relationship among debt, the real interest rate, and investment exists. This result offers an explanation as to why empirical studies that have focused on the reduced-form relationship between interest rates and debt are often inconclusive. At longer horizons, distortionary financing is important for the negative investment response to a debt expansion.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 479.

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Date of creation: 2011
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Handle: RePEc:red:sed011:479
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