Equilibrium Growth in a Small Economy Facing an Imperfect World Capital Market

Abstract

A growth model of a developing economy facing an upward sloping supply curve of debt is analyzed. Equilibrium is characterized by transitional dynamics in which consumption, capital, and debt converge to a common growth rate. The adjustment is through the debt-capital ratio, which drives the borrowing rate to a level at which growth rates are equalized. The economy is subject to two externalities: a production externality, associated with government expenditure and a financial externality associated with the upward sloping supply of debt. The tax structure that enables the decentralized economy to attain the first best optimum is characterized.

JEL Classification: F21, F41, O11, O41