Lecture 25: Debt dynamics, continued Now add the upward-sloping supply of funds curve. i includes a default premium, which depends in turn on db/dt. For debt-intolerant countries, best to keep b low to begin with. Otherwise, it may be hard to keep db/dt < 0, if world i* goes up, or exogenous slowdown in n. Possibility of unstable equilibrium API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

Debt dynamics graph, with possible unstable equilibrium Supply of funds line i Initial debt dynamics line { sovereign spread iUS API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

(1) Good times. Growth is strong. db/dt = 0, or if > 0 nobody minds (1) Good times. Growth is strong. db/dt = 0, or if > 0 nobody minds. Default premium is small. (2) Adverse shift. Say growth n slows down. Debt dynamics line shifts down, so the country suddenly falls in the range db/dt>0. => gradually moving rightward along the supply-of-lending curve. (3) Adjustment. The government responds by a fiscal contraction, turning budget into a surplus (d<0). This shifts the debt dynamics line back up. If the shift is big enough, then once again db/dt=0. (4) Repeat. What if there is a further adverse shift? E.g., a further growth slowdown (n↓) in response to the higher i & budget surplus. => b starts to climb again. But by now we are into steep part of the supply-of-lending curve. There is now substantial fear of default => i rises sharply. The system could be unstable…. API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted

=> explosive debt path API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Copyright 2007 Jeffrey Frankel, unless otherwise noted