Can higher debt lead to higher welfare? A theoretical and numerical analysis

This paper demonstrates, for a two-good, two-country model with finitely-lived agents, the possibility of using national debt as a policy instrument to improve welfare via an improvement in the terms of trade. The latter is large enough to outweigh the negative effect of crowding out of capital that results from higher debt. It is shown that without retaliatory behaviour, a welfare-maximizing level of debt is theoretically obtainable for values less than half the elasticity of substitution in consumption. For a substitution elasticity equal to half zero debt is the optimum.