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Debts , Deficits and the Real Interest Rate in an Endogenous Growth Model

This paper presents a model for analysing the effects of public expenditure and government debt on the real interest rate and the long run growth rate. The model proposed for this purpose belongs to a class of endogenous growth theories with investment adjustment costs, in which savings and investment are co-determined through adjustments in the real interest rate. The equilibrium investment rate determines the long-run growth rate, because of constant returns to capital accumulation due to externalities of the “learning by doing” type. We set up and compare two versions of the model, one with a representative household and one with overlapping generations. It is shown that the representative household and overlapping generations versions of the model have similar predictions regarding the effects of technological and preference shocks. However, for the same parameter values, the overlapping generations model predicts lower savings and investment, higher interest rates and lower growth rates that the corresponding representative household model. In addition, the overlapping generations model is not characterized by Ricardian equivalence. Thus, an increase in government expenditure or public debt causes an increase in the equilibrium real interest rate and a reduction in the long run growth rate.