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The Marginal Cost of Public FundsTheory and Applications$
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Bev Dahlby

Print publication date: 2008

Print ISBN-13: 9780262042505

Published to MIT Press Scholarship Online: August 2013

DOI: 10.7551/mitpress/9780262042505.001.0001

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The MCF from Public Sector Borrowing

The MCF from Public Sector Borrowing

Chapter:
(p.205) 8 The MCF from Public Sector Borrowing
Source:
The Marginal Cost of Public Funds
Author(s):

Bev Dahlby

Publisher:
The MIT Press
DOI:10.7551/mitpress/9780262042505.003.0008

This chapter focuses on the marginal cost of public funds (MCF) from public sector borrowing. The chapter is organized as follows. Section 8.1 begins with a brief overview of the postwar literature on the burden of the public debt. Section 8.2 uses the Diamond (1965) overlapping generations model to analyze the wealth effect of the public debt and to derive a measure of the marginal cost of funds from public sector borrowing. Section 8.3 analyzes the MCF from public sector debt when interest payments on the debt are financed by a distortionary tax on total output. Section 8.4 uses this framework to derive a rule for the optimal financing of lumpy expenditure projects—use debt financing to equalize over time the marginal cost of public funds through taxes. Finally, Section 8.5 uses a simple endogenous growth model, which incorporates the Ricardian equivalence effect and the distortionary tax effect, to derive a measure of the marginal cost of funds from public sector borrowing and to explore the connection between the level of public debt and the rate of economic growth. This model is used to compute the MCF from public sector borrowing in the Canada and the United States and to consider the effect of higher public debt on the optimal level of public expenditures.

Keywords:   marginal cost of public funds, public finance, public debt, distortionary tax, economic growth

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