Exogenous variations in public debt and the private output: addressing country heterogeneity and cross-sectional dependence in a large panel

Using projections from the IMF’s World Economic Outlook (WEO) database, we explore the links between public debt and the private sector by estimating the response of private output to debt shocks – defined as debt forecast errors. We address several econometric issues through a flexible dynamic panel framework that accommodates slope heterogeneity of the coefficients and cross-sectional dependence. The overall results suggest that positive shocks in public debt are detrimental to the dynamics of private output. Nevertheless, the effect becomes neutral if countries have followed a pattern of fiscal consolidation over the previous five years. The estimates at individual-level are consistent with the general findings, except for a small group of countries. For instance, a positive and significant effect of debt emerges only for one advanced country and seven emerging economies. Although high levels of indebtedness are associated with a rapid decline in the debt coefficients, a nonlinear effect in the form of a Laffer-type curve appears to be unlikely.