Optimal Growth under Flow-Based Collaterals

Some recent evidence on government finance statistics of European countries suggests that countries with public debt issues also show a low tax revenue-GDP ratio. In this paper we develop a small open economy model of endogenous growth in which the engine of growth is public spending. We assume that government can finance public expenditures by borrowing on imperfect international financial markets where her borrowing capacity is limited. In contrast to the existing literature, where debt is constrained by the stock of capital, the collaterals are based on GDP. The balanced growth path and the transitional dynamics are studied. First, we show that the economy may converge in a finite time to the regime with binding collateral constraint. Second, in such regime the steady state public expenditures-GDP ratio is greater than that of the models without collateral constraints and of the stock-based collaterals literature. Third, the model predictions are consistent with recent empirical literature: there exists a certain threshold of financial and institutional development and economic features that an economy needs to attain in order to benefit from financial liberalization. Finally, if the degree of financial markets imperfections is weak, technologically developed countries experience a higher long-run growth rate than that of the stock-based collaterals literature, otherwise the world interest rate need to be high enough.