Journal Article

Investment Cycles and Sovereign Debt Overhang

Mark Aguiar, Manuel Amador and Gita Gopinath

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 76, issue 1, pages 1-31
Published in print January 2009 | ISSN: 0034-6527
Published online January 2009 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/j.1467-937X.2008.00523.x
Investment Cycles and Sovereign Debt Overhang

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  • Macroeconomics: Consumption, Saving, Production, Employment, and Investment
  • Taxation, Subsidies, and Revenue
  • International Finance

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We characterize optimal taxation of foreign capital and optimal sovereign debt policy in a small open economy where the government cannot commit to policy, seeks to insure a risk-averse domestic constituency, and is more impatient than the market. Optimal policy generates long-run cycles in both sovereign debt and foreign direct investment in an environment in which the first best capital stock is a constant. The expected tax on capital endogenously varies with the state of the economy, and investment is distorted by more in recessions than in booms, amplifying the effect of shocks. The government's lack of commitment induces a negative correlation between investment and the stock of government debt, a “debt overhang” effect. Debt relief is never Pareto improving and cannot affect the long-run level of investment. Furthermore, restricting the government to a balanced budget can eliminate the cyclical distortion of investment.

Keywords: E22; F34; H21; H25

Journal Article.  16718 words.  Illustrated.

Subjects: Macroeconomics: Consumption, Saving, Production, Employment, and Investment ; Taxation, Subsidies, and Revenue ; International Finance

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