Question

Trace the cause-and-effect chain through which financing and refinancing of the public debt might affect real interest rates, private investment, the capital stock, and economic growth. How might investment in public capital and public-private complementarities alter the outcome of the cause-effect chain?

Short answer

The crowding-out effect by public debt will increase the real interest rate, reduce private investment, stock of capital, and economic growth.

Investment in public capital increases the availability of public stock for future generations, repairing the economic loss by the crowding-out effect. Investment in public-private complementarities increases the public and private investments simultaneously, which eliminates the crowding-out effect.

Step-by-step solution

Cause-and-effect chain of public debt

When the government falls short of the funds, it opts for debt. The public debt can be for productive purposes or to settle the preceding debts.The increase in public debts raises the interest rate, crowding out private investment.

A decline in private investment lowers the stock of capital and aggregate spending of the economy. A smaller aggregate spending will hamper economic growth.

Alteration of the outcome of the cause-and-effect chain

Investment in public capital such as transportation, health, education, or any other physical or social infrastructure creates excessive production capacity in the economy in the future.It repairs the economic loss caused by the crowding-out effect.

Public-private complementarities can reduce the crowding-out impact of private investment.If the public debt is used for productive purposes, increasing the demand for private investment, the private and public investments will grow simultaneously, flourishing the economic growth.

For instance, the government invests the public debt in setting up new hospitals in an underdeveloped area. It will encourage private investment for setting up pathologies, medical and other shops, hotels, and restaurants in the area.

Therefore, the public and private investments will complement each other, and the economy will experience growth.