Government Debt, Economic Activity, and Transmission of Economic Disturbances

This paper analyzes the effects of government debt on output and the trade balance in a two-country rational expectations model of the world economy. It is shown that perceived changes in government debt do not affect the level of economic activity but unperceived changes in the home country's government debt are are correlated positively with her output and negatively with her trade balance. Unperceived increases in the foreign country's government debt, however, have a positive impact on the home country's output and the trade balance. Empirical evidence for the U.S. is consistent with most of the implications of the model. (Printed by permission of the publisher.)