Public Debt, Terms of Trade and Welfare: The Role of Capital Production Shares, External Balances, and Dynamic (In)efficiency

In view of still large external imbalances across the world economy and dramatically risen public debts in major advanced economies, this paper reconsiders the relationship between public debt, the terms of trade and welfare in a two-good, two-country overlapping generations model with technological differences across countries. We find that the terms of trade effect of a public debt shock depends only on international differences in capital production shares and the dynamic (in)efficiency of the world economy. As in a model with similar capital production shares, domestic welfare rises and foreign welfare decreases when Home has a positive external balance and the Golden Rule holds. Under dynamic efficiency, welfare decreases in the debt-expanding, net foreign creditor country if she has a relatively smaller capital production share, and if the welfare effect through the accumulation channel is negative. In contrast, under dynamic inefficiency she can increase her welfare by debt expansion.