The recent dramatic rise of government deficits in most advanced countries to counter the adverse growth and employment effects of global financial crisis arouse concerns both with respect to the sustainability of government deficits and in a long-term view of government debt (Neck and Sturm 2008) and the stability of (real) exchange rates of highly indebted countries. Still high international integration of government bond markets makes it imperative to explore both limits for national government debt levels and impacts of larger national debt debts on the real exchange rates of internationally interdependent economies. While both topics have been investigated by Farmer and Zotti (2008) in a two-country overlapping generations’ model with internationally identical saving rates, there does not exist a comparable model of the world economy with country-specific (internationally differing) saving rates. Comparing Asian economies and the US economy, differing saving rates are a matter of fact. Moreover, in Farmer and Zotti’s (2008) two-country model a relatively high-indebted country always exhibits a net foreign debtor status which is at odds with the pre-crisis Japanese situation of both high government debt and a net foreign creditor position.There are thus two main objectives of the underlying paper: first to explore the existence and determinants of ‘maximum sustainable’ (Rankin and Roffia 2003) debt levels in a two-country overlapping generations’ model which is also able to mimic the Japan-US example; secondly, to investigate the impacts of unilateral national debt expansion below maximum sustainable debt on the real exchange rate and on private capital accumulation at home and abroad.
(2) Data / Methods
Methodologically spoken, we provide a theoretical study which is to be seen as preliminary to a full-blown dynamic CGE model. We extend Farmer and Zotti’s (2008) two-country overlapping generations’ model with equal saving rates into a two-country setting with internationally differing saving rates and government debt levels. Both countries in the model economy are interconnected through free trade in commodities and in bonds emitted by national governments. Within this model setting existence and interconnectedness of maximal national government debt levels as well as existence and dynamic stability of steady states and the transitional dynamics of private capital and the real exchange rate are analyzed when government debt levels remain below the limits.
(3) Results
In line with overlapping generations’ models without an operative bequest motive we find that maximum government debt levels for both countries exist and are negatively related. When the limits for national government debt levels are reached the world economy undergoes a saddle-node bifurcation, that is, it implodes suddenly. Moreover, if sustainable government debt is unilaterally expanded, private capital is crowded out in both countries while the real exchange rate of the debt-expanding country are unaffected if capital income shares are internationally equal. If the latter differ, the real exchange responds to the government debt shock, whether it rises or falls is, however, independent of the net foreign asset position of the more indebted country.