DURING THE LAST decade, the economic impact of the issuance of government debt is a topic that has received a great deal of attention from the media, politicians, and economists. As governments have significantly relied on government debt issue, the topic is worthy of that attention. The public has often been confused by what appears to be a wide variety of opinions regarding this subject. In this chapter, we hope to clarify the relevant issues. To do so, we will apply what we learned about wealth, consumption, and saving in the previous chapter to study the effects of the national debt.

The National Debt and the Crowding Out of Capital

Government bonds and capital are both assets through which people save. If the government increases the stock of bonds, does this mean that people will invest in less capital? We will address this question by examining two cases: one in which government deficits cause a reduction in capital investment and one in which the deficits have no effect on capital. The two cases differ only in a single assumption. This assumption will therefore prove to be the key to understanding when the size of the national debt is important to the size of the capital stock.

In both cases, we examine the overlapping generations economy developed in Chapter 14, of two-period-lived agents, each endowed with y1 goods when young and y2 when old.