1. 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 Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

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

3. (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 Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Copyright 2007 Jeffrey Frankel, unless otherwise noted

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