Excessive and cumulative public deficits might lead to an increase in the debt-to-GDP ratio, often used to measure the “weight” of public debt on the economy. In 2014, the average debt-to-GDP ratio for OECD countries was 94 percent. Apart from the argument put forward by some economists (refer to Problem 1.4) that excessive public debt levels are detrimental to economic growth, many governments are interested in reducing government debt because they pay interest on their debt and these payments are often an important item in government budgets. Assume that country A has GDP of $500 billion, total government debt of $450 billion, marginal propensity to save of 0.2, and government expenditure of $200, while tax receipts amount to $180. The government has just announced spending cuts of $20 billion next year with no change in taxation. Would a balanced budget and a debt-to-GDP ratio below the OECD average suffice? Why?

Data from problem 1.4

There has been considerable debate on the impact of high public debt on economic growth. The author of This Time Is Different, economists Carmen Reinhart and Ken Rogoff claim that there exists a “debt overhang”—a level of public debt beyond which economic growth is negatively affected by excessive government borrowing, though many other economists disagree. Using the OECD database, find the latest data on GDP growth and the level of public debt for Japan, the United States, and Germany. What do these numbers tell you about the “debt overhang” argument?