Public versus Private Provision of Liquidity: Is There a Trade-Off?

Many researchers have recommended to increase public debt in the aftermath of the fi nancial crisis in order to relax borrowing constraints for private households. This advice is based on the common assumption that borrowing conditions of private agents are exogenous to public policy. We study the impact of government debt on the provision of private credit in an economy in which borrowing limits arise because of limited contract enforceability and are thus determined as equilibrium outcomes. As such, they also depend on public policy, in particular on the amount of public debt. Using an incomplete markets economy in which households are subject to uninsurable earnings shocks, we show that an increase in government debt crowds out the supply of private credit. We also fi nd that government debt has signi ficantly different implications for aggregate welfare and economic activity in general if borrowing constraints are endogenous.