DP17529 Public Debt and the Balance Sheet of the Private Sector
Is the interest rate of an economy naturally higher than the rate of growth? Are permanent government budget deficits sustainable? This paper argues that the answer to these questions depends on the interplay between the balance sheets of the private and public sector and the weight of the corporate sector in political decision-making. We propose a simple growth model with incomplete markets and heterogeneous agents, featuring households and firms that face non-insurable idiosyncratic productivity shocks. More government debt reduces corporate leverage, increases the risk free rate r and decreases the growth rate g. An appropriate combination of public debt and taxes can implement the constrained social welfare optimum. The weight of firms in the government's welfare function determines whether r < g or r > g at the optimum, with quite different dynamics in these two regimes.