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 equilibrium is characterized.