The Debt Multiplier

Abstract

This paper studies the debt multiplier, that is, the effects of a temporary and pure change in government debt on economic activity. Contrary to an infinitely-lived representative agent model, in an overlapping generations (OLG) framework output increases even after a temporary increase in debt due to a lump-sum tax reduction that is totally reversed in the future. When nominal interest rates are positive, the debt multiplier is generally quite small. However, the debt multiplier is much larger when the nominal interest rate is at the zero lower bound. Hence, the call for fiscal consolidation in recession times seems ill-advised. Moreover, the steady state level of debt matters in an OLG framework. Multipliers tend to increase with the level of debt in steady state. A rise in the steady state debt-to-GDP level increases the steady state real interest rate and thus it provides an alternative route to increase the room for manoeuvre for monetary policy facing de flationary shocks.