Do debt and growth dance together? A DSGE model of a small open economy with sovereign debt

Regarding the financial crisis since 2008, one heated debate lies in the relationships between public debt and economic growth. The present paper develops a theoretical model in a small open economy with sovereign risk based on Galí  and Monacelli (2005, 2008). A country- specific sovereign risk parameter is inserted into the sovereign interest rate equation to analyze its influence to the links between debt and growth. This paper shows that there is no single threshold and additionally, the relationship between debt and growth is country-specific and it varies depending on the degree of sovereign risk. Three scenarios are considered conditional on one set of randomly drawn simulated exogenous shocks. In a country with a high sovereign risk, there is a negative relationship between debt and growth whereby debt- GDP ratio is above 90%. With an extremely high sovereign risk, the relationship turns out to be rather negative and the turning point is quite low. In some countries that sovereign risk is not that high, fiscal stimulus could be effective to improve the economic growth. Moreover, the relationships between debt and growth under the three scenarios are all hump-shaped.