Public debt dynamics

In this chapter, we will address the last economic question resulting from the chosen model framework: how does public indebtedness evolve and how does fiscal policy and financial market interaction influence this evolution? We will take ‘public debt per output’ (i.e. the debt ratio) as the appropriate measure for public indebtedness. The debt ratio is usually associated with the question whether a present stock of public debt is compatible with default-free future debt service which would guarantee intertemporal solvency of the government. This solvency question itself does, however, not stand in the foreground of this chapter. The reason is that we always assume that the tax rate and the public expenditure ratio are subject to those fiscal policy constraints developed in Chapter 3. These conditions were shown to fulfill the transversality condition, thereby ruling out Ponzi-game dynamics of public debt as pointed out by Obstfeld/Rogoff (1996, p. 717) 1. Thus, the main purpose in this chapter is to analyze the model dynamics of the debt ratio, especially with regard to the underlying parameters and variables characterizing fiscal policy and financial market behavior.