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Federal Reserve Bank of Chicago

The Relationship between Debt and Output

Yun Jung Kim and Jing Zhang

September 17, 2020
WP 2020-30
https://doi.org/10.21033/wp-2020-30
*

Working papers are not edited, and all opinions and errors are the
responsibility of the author(s). The views expressed do not necessarily
reflect the views of the Federal Reserve Bank of Chicago or the Federal
Reserve System.

The Relationship between Debt and Output∗
Yun Jung Kim
Sogang University

Jing Zhang
Federal Reserve Bank of Chicago†
September 17, 2020

Abstract
In this paper we empirically explore the relationship between debt and output in a panel
of 72 countries over the period 1970–2014 using a vector autoregression (VAR). We document two puzzling empirical findings that contrast with what is predicted by a standard
small open economy model by Aguiar and Gopinath (2007), where debt and output endogenously respond to total factor productivity (TFP) shocks. First, developing countries’
debt falls after a positive output shock, while the model predicts a debt expansion. Second, output declines in developed and developing countries after a debt shock, while the
model predicts higher output. The relationship between debt and output depends on the
sector taking on debt (households, firms, or governments) and the source of financing
(domestic versus external) and differs across countries with varying degrees of economic
development or different exchange rate regimes.
JEL Classifications: E44, F32, F34, F41
Keywords: public debt, household debt, firm debt, foreign debt

∗

The views expressed here are those of the authors and do not necessarily reflect the views of the Federal
Reserve Bank of Chicago or the Federal Reserve System. We thank Gadi Barlevy, Luojia Hu, Aart Kraay, and
participants of the 20th Jacques Polak Annual Research Conference for useful discussions and comments. We
also thank Erin Gibson for excellent research assistance.
†
E-mail: yunjungk@sogang.ac.kr, jzhangzn@gmail.com.

1

Introduction

The world has experienced a large increase in indebtedness. Figure 1 shows that the ratio of
total debt to gross domestic product (GDP) rose from 84.8 percent in 1970 to 168.6 percent in
2014. Overall, the global debt-to-GDP ratio reached an all-time high in 2018, generating many
concerns among both academic researchers and policymakers about what the ramifications for
global growth might be. Debt might be beneficial for smoothing consumption, accelerating capital accumulation, and increasing output, but increased debt services might also leave countries
vulnerable to financial risks and lower GDP in the medium run. To shed more light on the
discussion and provide support to policy analysis, we investigate empirically the dynamic relationship between debt and output. Understanding this relationship is critical for investigating
the mechanisms underlying the linkages between indebtedness and economic growth.
Figure 1: Global Debt to GDP, Percent

Note: The figure shows the average ratios of private and public debt
to one-year lagged GDP for 72 sample countries. Data comes from the
IMF’s Global Debt Database and the Historical Public Debt Database.

Not all debt is the same, nor is the relationship between debt and output the same across
countries. Debt expansions have different correlations with output dynamics depending on the
sector taking it on (households, firms, or governments). The relationship also depends on the
source of financing (domestic versus external). Importantly, the patterns of the relationship
differ across countries with varying degrees of economic development or different exchange
rate regimes. In this paper, we investigate the relationship between debt changes and output
dynamics along all these dimensions of the data.
The dynamics of output and debt are endogenous outcomes of underlying shocks and economic frictions in the data. To interpret the empirical findings, we generate simulated series of
debt and output using a standard small open economy model by Aguiar and Gopinath (2007),
in which debt and output endogenously respond to stochastic total factor productivity (TFP)
2

shocks with no fundamental real or nominal frictions. To explore the dynamic relationship
between output and debt, we conduct a vector autoregression (VAR) analysis on output and
debt in model-simulated data and actual data for developed and developing countries. The
model has only one form of debt—that is total debt. However, there are many relevant debt
statistics in the actual data, which allow us to investigate debt taken on by various economic
sectors and financed from different sources.
We document two puzzling empirical findings that contrast with what is predicted by the
baseline model. First, developing countries’ total debt falls below the initial level for several
years after a positive output shock, while the model predicts a debt expansion. Second, output
declines for several years in both developed and developing countries after a debt shock, while
the model predicts sustained higher output.
When dissecting the data further, we find that (i) an output shock decreases public debt,
but increases private debt—household and firm debt, in both groups of countries; (ii) a shock
to private debt suppresses future output, with a shock to firm debt lowering future output
and with a shock to household debt leading to a short-term boom followed by a medium-term
slump, particularly in developing countries; (iii) a shock to public debt decreases (increases)
future output in developed (developing) countries, although the relationship is not significant;
(iv) a shock to foreign debt suppresses future output more than a shock to domestic debt in
both groups of countries; and (v) the negative impact on output from a shock to household,
firm or foreign debt is more pronounced in countries with a fixed exchange rate regime than in
those with a floating exchange rate regime.
To guide the empirical investigation, we start by analyzing the dynamic relationship between
debt and output in an international business cycles model built by Aguiar and Gopinath (2007).
Their model features stochastic shocks that are primarily permanent on TFP trends in emerging
markets, but largely transitory on TFP levels in developed countries. We study the endogenous
dynamics of debt and output driven by estimated TFP shocks in this model with no other
fundamental frictions. The model provides two key implications. One is that a positive output
shock today reduces subsequent debt-to-output ratios in developed countries, but it increases
subsequent debt-to-output ratios in developing countries. The other is that an increase in debt
today is associated with higher subsequent output in both groups of countries.
The intuition for these model-implied relations is straightforward. Output growth in developed countries is driven mainly by transitory shocks, which induce savings to smooth consumption over a temporary windfall and thus reduce debt. In contrast, output growth in developing
countries is driven primarily by permanent trend shocks, which boost borrowing against a higher
permanent income and thus expand debt. In developed countries, debt growth is likely to be
driven by a negative transitory TFP shock, which implies higher subsequent output due to the
3

mean reversion of the transitory shock. In developing countries, debt growth is driven by a
positive trend shock, which leads to higher subsequent output. The model-implied relationship
between debt and output provides a useful benchmark for the empirical findings.
We next study empirically the relationship between debt and output in a panel of 72 countries over the period 1970–2014, using a panel VAR on output and the debt-to-lagged-output
ratios. We dissect total debt data by indebted economic sectors (households, firms, and governments) and by sources of financing (domestic and external). To shed light on the mechanisms
of the results, we examine countries with varying degrees of economic development (developed
and developing economies) and different exchange rate regimes (fixed and flexible). We also
investigate the impact of credit booms on the dynamics of consumption and investment.
We find strikingly different relations between debt and output in the data from those in the
baseline model. In the data, in response to a positive output shock, total debt declines in the
beginning for two years and then rises gradually, but it remains below the pre-shock level for
six years in both developed and developing countries. The absence of debt expansion after an
output shock in developing countries is particularly puzzling when considered relative to what
is predicted by the baseline model. In response to a debt shock, output declines persistently in
both groups, and the decline is much larger in developed countries than in developing countries.
For a one-percentage-point increase in the ratio of total debt and output, the peak magnitude
of the output reduction is 0.16 percent in developed countries and 0.05 percent in developing
countries. This empirical pattern is the opposite of what is expected according to the baseline
model, where the debt shock is associated with subsequent output growth.
We then examine relations between output and debt taken on by various economic sectors
and find that the relations differ substantially by sector. In response to a positive output shock,
public debt declines, while private debt rises, persistently in both developed and developing
countries, although the responses are weak in developing countries. For a one-percent output
shock, the ratio of private debt and output rises by 2.8 percentage points in developed countries,
but by only 0.6 percentage points in developing countries, and the ratio of public debt and
output decreases by 2.5 percentage points in developed countries, but only by 1.2 percentage
points in developing countries. Household debt and firm debt—two forms of private debt—rise
in response to an output shock in both groups of countries. The magnitude of the increase is
larger in developed countries.
How a debt shock is associated with subsequent output also differs greatly across these
economic sectors and across country groups. A shock to private debt suppresses future output
in both groups of countries. With respect to specific types of private debt, a shock to firm debt
lowers subsequent output and a shock to household debt leads to an output boom followed by
an output slump in both groups. The negative impact of a firm debt shock on output is larger
4

in developing countries. Also, the output boom due to a shock to household debt is much
smaller and short-lived in developing countries, followed by a much larger output decline for
many years. By the tenth year after the household debt shock, output in developing countries
remains 0.7 percent below the pre-shock level, and the decline is statistically significant at the
95 percent level. Overall, output declines by more in response to a shock to private debt in
developing countries than in developed countries.
On the other hand, a shock to public debt tends to decrease (increase) future output persistently in developed (developing) countries, although the coefficients are not significant. This
difference in the output responses to a public-debt shock between developed and developing
countries explains why a shock to total debt has a weaker negative association with future
output, although a shock to private debt—either firm or household debt— has a stronger negative association with future output in developing countries than in developed countries. The
empirical findings across economic sectors highlight the importance of modeling both private
and public debt concurrently in a quantitative model, which is absent in the baseline model.
Furthermore, we find that the impact of household debt and firm debt on subsequent output
differs substantially across different exchange rate regimes. In countries with a floating exchange
rate regime, the negative impact of household and firm debt on output is small and insignificant.
In countries with a fixed exchange rate regime, however, the negative impact on the mediumterm output is large and persistent. By the eighth year after the debt shocks, output remains
0.6 percent below the initial level in response to a one-percentage-point increase in the firm
debt to output ratio, and it remains 0.9 percent below the initial level in response to an increase
in household debt of the same size. These results suggest that nominal rigidities or constraints
on monetary policy might be important for understanding the linkage between expansions of
household or firm debt and declines in future output.
Turning to the source of debt financing, we find that a shock to foreign debt tends to
suppress future output more than a shock to domestic debt in both groups of countries. Since
foreign debt often is denominated in foreign currency, the exchange rate regime matters to a
large extent for the implication of holding foreign debt. In countries with a floating exchange
rate regime, a shock to either domestic or foreign debt has limited impacts on future output,
just as a shock to household or firm debt. However, in countries with a fixed exchange rate
regime, a shock to foreign debt significantly lowers future output for a sustained period of time.
By the tenth year after the shock, output remains 0.22 percent below trend, in response to a
one-percentage-point increase in the foreign-debt-to-output ratio.
Lastly, we investigate the impact of credit booms to the subsequent consumption and investment. In both groups of countries, a shock to household debt is the driving force behind
the dynamics of consumption and investment: after the household debt shock, both consump5

tion and investment experience an initial boom followed by a sustained slump. Quantitatively,
the booms are small, short-lived, and insignificant, but the subsequent declines are large and
significant in developing countries. By contrast, the initial booms are large and persistent,
and the subsequent slumps are small in developed countries. Shocks to either firm debt or
public debt tend to have only a small, insignificantly negative impact on future consumption
and investment in developed countries. Developing countries share similar patterns with one
exception. A shock to firm debt reduces subsequent investment substantially: in response to a
one-percentage-point increase in the ratio of firm debt and output, the decline in investment is
1.1 percent in the fourth year and remains significantly negative.
There is a large empirical literature on the role of debt in macroeconomic stability and
continued growth. These studies have focused on either private sector debt, public sector debt,
or external debt, of particular sample groups. We build on this literature by examining a
large set of countries with a comprehensive set of debt statistics. Reinhart and Rogoff (2009)
illustrate the history of debt, crisis, and growth, and they document that when debt ratios
are beyond a certain level, financial crises become more likely and severe. There is a large set
of recent studies analyzing the empirical relationship between government debt and economic
performance. Reinhart and Rogoff (2010) find that countries with public debt over 90% of GDP
experience notably slower growth.1 Several papers (Cecchetti et al. 2011; Cecherita-Westphal
and Rother 2012; Baum et al. 2013; Panizza and Presbitero 2014; Kumar and Woo 2015) have
estimated versions of the dynamic growth model to alleviate omitted variable bias and concerns
of reverse causality and find mixed evidence of the threshold effect.
Concerns with the growth of private sector debt have emerged more recently. Using the
historical data constructed by Schularick and Taylor (2012) for advanced economies, Jorda et
al. (2013) show a systematic link between private sector credit booms, financial crises, and slow
growth. While household debt booms and busts in advanced economies have attracted much
attention since the Great Recession, the buildup of corporate debt in emerging markets, notably
China, is now raising concerns. Cecchetti et al. (2011) study 18 OECD countries from 1980 and
2010 and find that beyond a certain level, corporate debt is a significant drag on growth, while
the estimates for household debt are insignificant. In contrast, the recent work by Mian et al.
(2017) shows that an increase in the household-debt-to-GDP ratio predicts lower GDP growth
in the medium run for an unbalanced panel of 30 countries over the period 1960–2012. In their
1

This finding inspired extensive follow-up studies that provide mixed results. Cecchetti et al. (2011), Padoan
et al. (2012), Cecherita-Westphal and Rother (2012), and Baum et al. (2013) confirmed this finding for similar
sets of countries. Nevertheless, Caner et al. (2010), Elmeskov and Sutherland (2012), Baglan and Yoldas (2016),
Eberhardt and Presbitero (2015), Herndon et al. (2013), Pescatori et al. (2014), and Egert (2015) showed that
finding a negative non-linear relationship is extremely difficult and sensitive to modeling choices and data
coverage.

6

study, the growth in corporate debt does not imply a slower rate of output. Park et al. (2018)
extend Mian et al. (2017) to include emerging market countries. Bernardini and Forni (2017)
study a sample of emerging economies and find that both private debt buildup and public debt
buildup exacerbate the duration and intensity of recessions.
A related literature has focused on the role of external debt in growth, particularly among
developing countries. The Asian financial crisis in 1997–98 and sovereign debt crisis of Latin
American countries in the 1980s have attracted a large deal of attention to the potentially
adverse implications of external debt. Patillo et al. (2002) show that for a country with average
indebtedness, doubling the external debt ratio would lower annual growth by between 0.5 and 1
percentage point. Similarly, Chowdhury (2001) finds that the negative relationship between external debt and growth holds for both heavily indebted poor countries (HIPC) and non-HIPC.
Several other studies find mixed results. Lin and Sosin (2001) find a strongly negative relationship between external debt and growth in African countries, but no statistically significant
relationship in Latin American and Asian countries. Changyong et al. (2012) find that the
impact of foreign debt on economic growth depends on the degree that debt is transformed
into investment. Using Pakistan as a case study, Ramzan and Ahmad (2014) find that external
debt has a negative impact on economic growth, but this negative effect can be reduced, or
even reversed, in the presence of sound macroeconomic policy.
The remainder of the paper is organized as follows. In Section 2, we lay out the baseline
model and present key model mechanisms. In Section 3, we describe data sources and summarize
the key features of the data. In Section 4, we discuss the findings from the empirical analysis
we conducted to study the dynamic relationship between debt and output. Finally, we present
our conclusions in Section 5.

2

Baseline Model

We need to organize our empirical investigation of the relationship between debt and output.
To do so, we first analyze this relationship as implied by a standard international business
cycles model. Specifically, we select the model framework in Aguiar and Gopinath (2007)
for two main reasons. First, the model is a workhorse small open economy model, featuring
stochastic TFP shocks as the driving force for both output and debt dynamics. Second, the
model is successful in replicating distinct features of business cycles in developed and developing
countries with estimated TFP shock differences across these two groups. Specifically, shocks are
primarily permanent on TFP trends in emerging markets, but largely transitory on TFP levels
in developed countries. Thus, this model offers us an opportunity to study the endogenous
dynamics of debt and output growth under empirically relevant TFP shocks without other
7

fundamental frictions. The model-implied relationship between debt and output will provide a
useful guide when we examine and interpret the empirical findings.
We now lay out the key ingredients of the model. The production function is Cobb-Douglas
in capital Kt and labor Lt :
Yt = ezt Kt1−α (Γt Lt )α ,
where α is labor’s share of output Yt . There are two productivity processes—zt and Γt —with
different stochastic properties. The transitory shock zt follows a first order autoregressive, or
AR(1), process
zt = ρz zt−1 + zt ,
where ρz is the persistence parameter, and zt is independently and identically drawn from a
normal distribution with mean zero and standard deviation σz . Γt is the cumulative product
of the growth rate shocks: Γt = egt Γt−1 = Πts=0 egs , and gt follows an AR(1) process
gt = (1 − ρg )µg + ρg gt−1 + gt ,
where ρg is the persistence parameter, µg is the unconditional mean, and gt is independently
and identically drawn from a normal distribution with mean zero and standard deviation σg .
t
We normalize nonstationary variables Xt by Γt−1 , and denote detrended variables by xt = ΓXt−1
.
In detrended form, the representative agent’s problem can be written recursively as follows:
(
)
1−σ
(cγ (1 − L)1−γ )
V (k, b, z, g) = max
+ βeeγ(1−σ) EV (k 0 , b0 , z 0 , g 0 ) ,
c,L,k0 ,b0
1−σ
subject to
g 0

z+gα 1−α

c+e k =e

k

φ
L + (1 − δ)k −
2
α



eg k 0
− eµg
k

2

k − b + qeg b0 .

Consumption is denoted by c, and the level of outstanding debt is given by b. β is the discount
factor, σ is the risk aversion parameter, γ is the consumption exponent in utility, and q is the
price of debt.2 Capital depreciates at the rate δ, and adjustments incur a quadratic cost given
by the third term on the right-hand side of the constraint, where φ is the cost parameter.
We use the parameter values estimated by Aguiar and Gopinath (2007). Table 1 summarizes
2

The price of debt takes the form used in Schmitt-Grohe and Uribe (2003):
1/q = 1 + r? + ψ [exp (b0 − b) − 1] ,

where r? is the world interest rate, b is the steady-state level of debt, and ψ captures the elasticity of the interest
rate to changes in debt levels. In choosing b0 , the representative agent does not internalize the upward-sloping
supply schedule. This feature is introduced to make assets in the linearized model stationary. Quantitatively ψ
is set close to zero so that the short-run responses are unaffected by this schedule.

8

the parameter values at the quarterly frequency. The non-productivity parameters are standard
in the literature and common across developed and developing countries. For the productivity
process, the baseline estimation sets µg , ρg , and ρz to be the same across the two groups and
estimates σg and σz using generalized method of moments (GMM). The estimated σg is higher
in developing countries than in developed countries: 2.81 versus 0.88. The estimated σz is
higher in developed countries than in developing countries: 0.78 versus 0.48. Thus, shocks to
trend growth are the primary source of fluctuations in emerging markets, while both transitory
and trend fluctuations characterize developed countries.
Table 1: Parameter Values
Common non-TFP parameter
Discount factor
Risk aversion
Consumption exponent
Labor exponent
Depreciation rate
Capital adjustment cost
Interest premium coefficient

TFP parameter
β
σ
γ
α
δ
φ
ψ

0.98
2.00
0.36
0.68
0.05
4.00
0.001

µg
ρg
ρz
σg
σz

Developed

Developing

1.006
0.01
0.95
0.88
0.78

1.006
0.01
0.95
2.81
0.48

Note: The steady-state debt-GDP ratio b is set at 0.1, which does not affect the results.

The main contribution of Aguiar and Gopinath (2007) is to demonstrate that the differences
in the TFP shock process between developed and developing countries can account for two
distinct features of business cycles across these two groups of countries. One is that the trade
balance is more countercyclical in emerging markets than in developed countries. The other
is that consumption is more volatile than output in emerging markets while consumption is
slightly less volatile than output in developed countries. The intuition of these results can be
illustrated by Figure 2, which contrasts the impulse responses of key model variables following
a one percent growth shock (solid lines) with those following a one percent transitory shock
(dashed lines) in the first quarter. We plot the impulse responses at the annual frequency by
aggregating across four quarters, to be consistent with subsequent empirical work in which data
on debt statistics are available only annually.
Panel (a) of Figure 2 shows that the representative agent expects a boost to current output
and an even larger boost to future output following a growth shock, but she expects only a
temporary boost to output following a transitory shock. The permanent income hypothesis
implies that consumption jumps up substantially on impact and continues to rise to the new
steady state in response to a growth shock, but it rises moderately on impact and then gradually
declines back to the initial steady state in response to a transitory shock, which is shown in
panel (b). Investment responds more in the short run to a transitory shock than to a growth
shock, as shown in panel (c). As shown in panel (d), following a growth shock, the trade
9

Figure 2: Impulse Responses

(a) GDP

(b) Consumption

(d) Net Export/GDP

(c) Investment

(e) Debt/GDP

Note: The figure shows the impulse response of output, consumption, investment, net export to GDP, and debt to GDP in
response to a one percent shock to g (solid line) and z (dashed line). The values plotted are deviations from the steady state.

balance turns negative (i.e., there is a trade deficit) to accommodate the boost in consumption
and investment in the short run. In contrast, a transitory shock generates a trade surplus in
the short run as the country is smoothing the transitory income shock. Hence, in response
to a growth shock, the trade balance is strongly countercyclical on impact, and consumption
responds more than output in the short run, implying a larger consumption volatility than that
of output. The opposite is true in the case of a transitory shock: consumption is less volatile
than output, and the trade balance is procyclical. Given that the growth shock is more (less)
important in developing (developed) countries, the model successfully replicates the distinct
features of business cycles in the two groups.
Our focus is on the joint dynamics of debt and growth, so we extend their analysis to debt
dynamics across the two groups of countries. Panel (e) of Figure 2 plots the impulse responses of
the debt-to-output ratio

Bt+1
Yt

in terms of percentage differences from the initial steady state. In

response to a growth shock, the debt-to-output ratio rises as the country borrows and the trade
balance quickly deteriorates, resulting in a trade deficit in the first five years, and then the debtto-output ratio gradually declines as the trade balance improves, resulting in a trade surplus.
In contrast, in response to a transitory shock, the debt-to-output ratio declines substantially

10

in the short run as the country saves and the trade balance improves dramatically, resulting
in a trade surplus in the first eight years, and then the debt-to-output ratio rises as the trade
balance deteriorates, resulting in a trade deficit. The striking difference in debt dynamics in
response to the growth and transitory shocks drives the different patterns of the joint dynamics
of debt and output between developed and developing countries, which we turn to next.
Figure 3 presents the cross-correlation between changes in the debt-to-output ratio and
output growth in the model simulations. Panel (a) illustrates the patterns for developed
countries, and panel (b) illustrates those for developing countries. The correlations between
changes in the debt-to-output ratio ∆ BYt+1
and output growth ∆ ln Yt+k are plotted for different
t
k = −5, −4, ..., 4, 5. When k = 0, both groups display a positive contemporaneous correlation,
but the correlation is much larger in developing countries than in developed countries. That
is, when the output growth rate is high, the debt-to-output ratio increases in both groups.
Moreover, the debt-to-output ratio rises by substantially more in developing countries because
they are more likely to experience a growth shock, which implies larger trade deficits.
Figure 3: Cross-Correlations between Debt and Growth

(a) Developed Countries

(b) Developing Countries

Note: The figure shows the cross-correlation between changes in the debt-to-output ratio (∆
(∆ ln Yt+k ) for different k = −5, −4, ..., 4, 5, computed from the model simulations.

Bt+1
)
Yt

and output growth

When k < 0, the cross-correlation tells how past output growth relates to the current debtto-output ratio. In developed countries, these correlations are negative up to k = −1. That is,
developed countries that experienced faster growth three years ago are likely to have a lower
debt-to-output ratio today. In developing countries, these correlations are generally positive,
implying that such countries that experienced faster growth three years ago are likely to have
a higher debt-to-output ratio today. This is consistent with the impulse responses of output
and debt in Figure 2. Output growth in developed countries is driven mainly by positive,
transitory shocks, which lead to declines in subsequent debt-to-output ratios for several years.
In contrast, output growth in developing countries is driven primarily by positive growth shocks,
11

which generates higher debt-to-output ratios in the next five years.
When k > 0, the cross-correlation tells how an increase in the debt-to-output ratio today
relates to subsequent future output growth. In developed countries, the correlations peak
after one year and then decline afterwards, but they remain positive. That is, countries that
experienced an increase in debt are likely to have faster growth in the coming several years. A
similar pattern shows up for developing countries, although their correlations peak at k = 0.
This is consistent with the impulse responses of output and debt in Figure 2. In developed
countries, a high debt-to-output ratio today is likely the result of a recent negative transitory
TFP shock, which leads to borrowing to smooth consumption. The mean reversion of the
transitory shock implies that growth is likely to pick up in the following years. In developing
countries, a high debt-to-output ratio today is likely to be the result of a recent high growth
rate shock, which induces borrowing and a trade deficit. On the one hand, because output
continues to grow in response to a positive growth shock for several periods, output growth is
likely to be high in subsequent periods, implying a positive correlation. On the other hand, the
growth shock has low persistence, so the correlation drops quickly, compared with the case for
developed countries.
We conclude this section by summarizing the key implications of the quantitative small open
economy model by Aguiar and Gopinath (2007) for the joint dynamics of output and debt in
developed and developing countries. Contemporaneously, the debt-to-output ratio and output
growth are positively correlated in both groups of countries, and the correlation is larger in
developing countries than in developed ones. If they experienced faster output growth several
years ago, developed countries are likely to have a lower debt-to-output ratio today, while
developing countries are likely to have a higher debt-to-output ratio today. If they experience
an increase in debt today, both developed and developing countries are likely to have faster
growth over the coming years. These theoretical predictions informed and helped guide our
empirical investigation on the relationship between debt and output.

3

Data

This section describes the data for the empirical investigation of the relationship between debt
and output. The baseline model is stylized with only one form of debt for the economy. In
the actual data, however, there are many relevant debt statistics, in addition to total debt
of the economy. For instance, we have debt statistics according to the sector taking on the
debt—namely, private debt and public debt, which are debt issued by the private sector and
the public sector, respectively. Within the private debt category, the data are further classified
as debt taken on by households and firms separately. There are also debt statistics according
12

to the source of financing—that is, domestic debt and foreign debt, which are debt financed
from domestic creditors and external creditors.
We study all these forms of debt in the empirical investigation for two reasons. First, it is
important to understand whether these types of debt relate to output growth in similar ways.
For example, does private debt respond to an output shock similarly as public debt, and does
future output respond to a private debt shock similarly as a public debt shock? Second, it is
useful to test whether the model captures the behavior of a certain type of debt in the data. Is
it household debt or firm debt that responds to an output shock and impacts future output in
a way consistent with the model?
To examine the empirical relationship between debt and output, we collected a large panel
data set of 72 countries over the period 1970-2014. Specifically, we have 21 developed countries
and 51 developing countries.3 For macroeconomic variables, we collect data on real GDP and
its components from the World Development Indicators database by the World Bank. For debt
statistics, we retrieve series of total debt, private debt, and public debt from the IMF’s Global
Debt Database and Historical Public Debt Database. Total debt is the sum of private debt and
public debt. Private debt is the total stock of loans and debt securities issued by households and
non-financial corporations. Public debt is gross debt issued by the public sector. For a smaller
sample of 56 countries, we have household debt and firm debt separately, but the coverage
is unbalanced over time. Most developed countries have full coverage, while most developing
countries start in the mid-1990s. We also collect data on foreign debt, which is defined as net
debt financed by foreigners using the 2016 update of the External Wealth of Nations Mark II
database by Lane and Milesi-Ferretti (2007). The difference between total debt and foreign
debt gives us a proxy for the debt financed by domestic agents, which we refer to as domestic
debt.
We report the summary of debt statistics as a percentage of lagged GDP in the left panel
of Table 2 for the samples of the developed and developing countries. The developed countries
on average have double the total debt of the developing countries: the total-debt-to-GDP ratio
is 188 percent in the developed countries and only 91 percent in the developing countries. The
private sector borrows substantially more in the developed countries (with a private-debt-toGDP ratio of 130 percent) than in the developing countries (47 percent). A similar pattern
shows up for both households and firms. The household-debt-to-GDP ratio is on average 56
percent in the developed countries, but only 22 percent in the developing countries. The firmdebt-to-GDP ratio is 83 percent in the developed countries, but only 48 percent in the developing
countries. This is not surprising given that the degree of financial development—often measured
by the ratio of private debt and GDP—is highly correlated with income. The ratio of public
3

The list of countries is described in the Appendix, Table A1.

13

Table 2: Summary of GDP and Debt/GDP, Percent
level
Developed Countries
GDP
Total Debt/GDP
Public Debt/GDP
Private Debt/GDP
Household Debt/GDP
Firm Debt/GDP
Domestic Debt/GDP
Foreign Debt/GDP
Developing Countries
GDP
Total Debt/GDP
Public Debt/GDP
Private Debt/GDP
Household Debt/GDP
Firm Debt/GDP
Domestic Debt/GDP
Foreign Debt/GDP

one-year change

mean

median

std.

mean

median

std.

187.95
57.47
129.94
56.13
83.43

183.50
51.41
123.29
52.97
81.38

64.32
34.10
50.29
26.67
30.40

1.84
3.78
1.31
2.39
1.30
1.25

1.97
3.51
0.72
2.04
1.17
0.81

2.47
8.01
4.92
6.33
2.74
5.36

178.11
9.84

162.73
11.08

79.88
41.05

3.57
0.27

3.41
0.08

11.60
8.88

91.02
44.12
47.07
21.79
48.16

82.30
39.03
34.63
16.73
41.68

46.03
29.41
36.50
17.67
27.96

2.34
1.87
0.45
1.36
1.02
1.18

2.78
1.56
0.05
1.06
0.72
1.05

5.17
10.12
8.20
6.11
2.73
5.06

78.00
13.01

60.51
20.96

67.15
53.98

1.75
0.07

1.26
0.05

13.12
10.89

debt and GDP for developed countries (57 percent) is larger than that for developing countries
(44 percent), but this difference is much smaller than the difference between their the privatedebt-to-GDP ratios. Thus, the public sector accounts for a disproportionately larger share of
total debt in the developing countries than in the developed countries.
With respect to the credit statistics, our data show that domestic debt is much larger in
the developed countries than in the developing countries, while the foreign-debt-to-GDP ratio
is higher in the developing countries than in the developed countries. Given their smaller
magnitude of total debt to GDP, the developing countries disproportionately finance their total
debt using external resources relative to the developed countries.
The right panel of Table 2 reports the summary statistics for annual GDP growth and
changes in debt-to-output ratios.4 The mean and median annual GDP growth rates are 1.84%
and 1.97%, respectively, for the developed countries. The mean and median annual growth
rates for the developing countries are higher at 2.34% and 2.78%, respectively. The standard
deviation in GDP growth is also much larger in the developing countries than in the developed
countries: 5.17 versus 2.47.
In the developed countries, household, firm, and public debt as a share of GDP have been
rising at a similar rate of 1.3 percentage points per year on average. The average one-year
4

GDP growth is measured by the percent change in log real GDP. Changes in debt ratios are measured by
the percentage-point difference in debt/GDP ratios.

14

changes for household and firm debt as a share of GDP are slightly lower in the developing
countries than in the developed countries. The public-debt-to-GDP ratio increases much more
slowly in the developing countries than in the developed countries: on average 0.5 versus 1.3
percentage points. Thus, total debt as a share of GDP has been growing much faster in
developed countries than in the developing countries: on average 3.78 versus 1.87 percentage
points. The average one-year change in the foreign-debt-to-GDP ratio is low (0.3 percentage
points in the developed countries and 0.1 percentage points in the developing countries). As
for the volatility of debt changes, the public-debt-to-GDP ratio in the developing countries
is more volatile than that in the developed countries: 8.20 versus 4.92 standard deviations.
The standard deviations are similar across the two groups for private debt and its components
(household and firm debt).

4

Empirical Findings

In this section, we discuss the findings from our empirical investigation on the relationship
between debt and output in developed and developing countries using a vector autoregression
analysis. To be upfront, the analysis is not intended to identify causal patterns. The VAR
is commonly used to uncover the full dynamic relations between multiple time series in the
empirical literature. Specifically, we estimate a VAR in log real GDP and the debt-to-GDP
ratios.
For debt statistics, we focus on not only total debt, but also debt taken on by different
sectors (households, firms, and governments) and financed from different sources (domestic and
foreign creditors). Debt statistics are normalized by one-year lagged GDP instead of current
GDP to avoid capturing innovations to GDP in the debt equations. The structural shocks are
identified through a Cholesky decomposition, with log real GDP ordered first. The lag orders
are set to be five.5 We run a panel VAR with country fixed effects for developed and developing
countries separately. Following Mian et al. (2017), we employ an iterative bootstrap procedure
to correct for potential Nickell bias from the inclusion of country fixed effects. To construct
confidence intervals, we use bootstrap methods using resampling based on the bias-corrected
estimates.
We also conduct the same analysis on model-simulated data and contrast model-implied
relations with empirical relations between debt and output. To be specific, we generate two
sets of simulated series of log output and the debt-to-output ratio at the annual frequency using
the calibrations for developed countries and for developing countries. Then we estimate a VAR
model with (log(Yt ), Bt /Yt−1 ) on each set of simulated data. The comparisons between the
5

The results are not sensitive to the choice of the lag order or to the ordering of the variables.

15

model-implied and empirical relations offer insights on mechanisms underlying the empirical
relations.

4.1

Total Debt and Output

Our aim is to study the relationship between total debt and output. Figure 4 presents the impulse responses from the VAR model with output and the total-debt-to-GDP ratio. Dashed lines
around the impulse responses are 95% confidence intervals computed with the bias-corrected
bootstrap. Both panels on the left are for developed countries, and both panels on the right are
for developing countries. In each panel, the red lines with squares are for the model simulations,
and the black lines with circles are for the data. The panels in the top row plot the impulse responses of the total-debt-to-output ratio (in percentage points) to a one-percent positive shock
to output, and the panels in the bottom row plot the impulse responses of output (in percent)
to a positive shock to the total-debt-to-output ratio by one percentage point.
Figure 4: Impulse Responses: Total Debt and Output

(a) Developed Countries

(b) Developing Countries

Notes: The figure presents impulse responses from a two-variable VAR in log real GDP and the ratio of total debt and GDP,
estimated in the data and in the model. The solid lines are the responses to a one-percent shock in each variable, and the
dashed lines are 95% confidence intervals computed with the bias-corrected bootstrap.

Let’s first look at the responses of total debt to a positive output shock. In the baseline
model, total debt persistently declines for many years in developed countries, while it rises above
the initial level for many years in developing countries. These patterns are the result of the
model mechanisms. A positive transitory shock that boosts output induces saving to smooth
consumption and reduces total debt for many years in the simulated developed countries. In
16

contrast, a positive growth rate shock that boosts output leads to an increase in debt on impact
and in subsequent years in the simulated developing countries. In the data, total debt declines
briefly for two years and then rises above the initial level in five years after the income shock in
both groups of countries. The peak reduction in the debt-to-output ratio is larger in developed
countries than in developing countries: 1.4 versus 0.9 percentage points.
We next look at the output responses to a positive shock to the total-debt-to-output ratio.
The baseline model implies that in response to a debt shock, output rises by a similar magnitude
for many years in developing and developed countries, as shown by the red lines with squares.
This is consistent with the positive cross-correlations between

Bt+1
Yt

and ∆Yt+k when k is positive,

shown in section 2. The data presents different patterns from those of the baseline model. In
both groups of countries, an increase in the debt-to-output ratio leads to a persistent decline
in output. However, the persistence and the magnitude of the decline are much greater in
developed countries than in developing countries. At the peak, the decline in output is 0.16
percent in developed countries and only 0.05 percent in developing countries. By the tenth year
after the debt shock, output is still below trend by about 0.14 percent in developed countries,
but it returns to the level before the debt shock in developing countries. Although the 95%
confidence bands are relatively wide, the negative impact of an increase in debt on output is
statistically significant between the second year to eighth year in developed countries.
In sum, the empirical relations between debt and output present two striking patterns that
are different from the predictions by the baseline model. The first difference is that after an
increase in debt in both groups of countries, the model implies a persistent increase in output,
while the data shows a persistent decline in output, particularly in developed countries. The
other difference is that after a positive income shock in developing countries, the model predicts
a persistent rise in the debt-to-output ratio, but the data shows a persistent reduction of debt.
These discrepancies between the empirical findings and the predictions made by a frictionless
model illustrate the importance of frictions in the real world absent in the baseline model.

4.2

Public Debt, Private Debt, and Output

Total economy-wide debt is the sum of debt in the private sector and in the public, or government, sector. To understand the behavior of total debt, we examine the behavior of its
components. Specifically, we explore the relations between output, public debt, and private
debt in a three-variable VAR regression. The impulse responses of private and public debt to
a positive output shock are plotted in the top row panels of Figure 5. The impulse responses
of output to a positive shock to either private or public debt are plotted in the bottom panels
of Figure 5.
In response to an income shock, both groups of countries experience a persistent increase
17

Figure 5: Impulse Responses: Public Debt, Private Debt, and Output

(a) Developed Countries

(b) Developing Countries

Notes: The figure presents impulse responses from a three-variable VAR in log real GDP, the public-debt-to-GDP ratio, and
the private-debt-to-GDP ratio. The solid lines are the responses to a one-percent shock in each variable, and the dashed lines
are 95% confidence intervals computed with the bias-corrected bootstrap.

in private debt and a persistent decline in public debt. The magnitudes of the debt responses,
however, are much larger in developed countries than in developing countries for both private
and public debt. In response to a one percent output shock, the ratio of private debt to output
rises as much as about 2.8 percentage points in developed countries, but it rises only about
0.6 percentage points in developing countries. The public-debt-to-output ratio declines by
2.5 percentage points in developed countries, but by only 1.2 percentage points in developing
countries. As shown in the previous section, private debt accounts for a larger share of total
debt than public debt in developed countries, while in developing countries private and public
debt are of a similar magnitude. This composition difference, together with the dynamics of
each type of debt, accounts for the responses of total debt to an output shock.
In response to a private debt shock, output declines substantially in both groups of countries.
The declines in the third year following the shock are statistically significant, and the magnitude
of the declines is substantial, particularly in developing countries. Output is down by 0.27
percent in developing countries and by 0.20 percent in developed countries in the sixth year
after the shock. In response to a public debt shock, output declines in developed countries,
but it rises in developing countries. That said, the confidence bands of output’s responses
to the public debt shock are wide and the responses are not statistically significant. This
difference in the output responses to a public-debt shock between developed and developing

18

countries explains why a shock to total debt has a weaker negative association with future
output, although a shock to private debteither firm or household debt has a stronger negative
association with future output in developing countries than in developed countries.
These findings illustrate two striking differences between private debt and public debt. First,
in response to an output shock, public debt declines while private debt increases in both groups
of countries. Second, an increase in private debt substantially decreases future output in both
groups, while an increase in public debt tends to increase future output in developing countries.
Thus, it is important to differentiate the source of a debt shock: it is a shock to private debt,
not public debt, that significantly and negatively impacts the medium-term output in both
groups of countries.
The empirical findings across economic sectors highlight the importance of modeling both
private and public debt concurrently in a quantitative model, which is absent in the baseline
model. The systematic interactions between public and private debt across the two groups of
countries are the key to understanding the dynamics of total debt. Most existing theories in
the literature focus on either type of debt or total debt. Kim and Zhang (2020) make some
progress by documenting and rationalizing the patterns of capital inflows to private and public
sectors in developed and developing countries.

4.3

Household Debt, Firm Debt, and Output

We further explore the two primary subcategories of private debt: household debt and firm
debt. We run a three-variable VAR regression of output, firm debt, and household debt for
developed and developing countries, and plot the impulse responses in Figure 6. In response
to an output shock, firm and household debt rise in both groups of countries. Firm debt has
a larger response to the output shock than household debt in developed countries, and both
forms of debt respond similarly in developing countries. In response to a firm debt shock, output
tends to be persistently below the initial level in developing countries. The negative impact
of firm debt on output is relatively small in developed countries. In response to a household
debt shock, output rises for several years and then falls below the initial level after five years
in developed countries. The impact of a household debt shock on output is mainly negative
in developing countries. The magnitude of output declines is larger and more significant in
developing countries than in developed countries.
Theories that link credit booms to lower subsequent growth rely on frictions, such as financial
frictions, nominal rigidities, or constraints on monetary policy. Examples include Curdia and
Woodford (2010), Eggertsson and Krugman (2012), Martin and Philippon (2017), Farhi and
Werning (2016), Korinek and Simsek (2016), Schmitt-Grohé and Uribe (2016), and Guerrieri
and Lorenzoni (2017). In these works, constraints, frictions, or rigidities exacerbate negative
19

Figure 6: Impulse Responses: Household Debt, Firm Debt, and Output

(a) Developed Countries

(b) Developing Countries

Notes: The figure presents impulse responses from a three-variable VAR in log real GDP, the ratio of firm debt to GDP, and
the ratio of household debt to GDP. The solid lines are the responses to a one-percent shock in each variable, and the dashed
lines are 95% confidence intervals computed with the bias-corrected bootstrap.

shocks and lead to adverse outcomes in economic growth, when debt expansions or credit booms
stall. To shed light on these mechanisms, we study the relations of household and firm debt
with output across exchange rate regimes of different rigidities, which broadly captures the
macroeconomic rigidities across countries.
We look at countries with a fixed exchange rate regime versus a floating exchange rate
regime. We divide the sample into fixed and floating exchange rate regimes based on the de
facto exchange rate regime from Reinhart and Rogoff (2004), which was updated in Ilzetzki
et al. (2017). “Fixed regimes” are regimes with no separate legal tender, currency boards,
pegs, and narrowly defined horizontal bands (coarse ERA code 1 from Ilzetzki et al., 2017).
“Floating regimes” are regimes with widely defined horizontal bands, crawling pegs, crawling
bands, moving bands, managed floats, and freely floating regimes (coarse ERA codes 2 to 4).
We classify countries in the fixed or floating exchange regime according to their average ERA
codes. We conduct the VAR analysis for these two samples by exchange rate regime.
Figure 7 reports the impulse responses by exchange rate regime for the VAR with output,
household debt and firm debt. View the results for the countries with floating exchange rate
regimes in the panels on the left. A positive output shock reduces both the household-debtto-output ratio and the firm-debt-to-output ratio—significantly so for up to four years. An
increase in firm debt barely changes future output, and an increase in household debt leads to

20

Figure 7: Impulse Responses across Exchange Rate Regimes:
Household Debt, Firm Debt, and Output

(a) Floating Exchange Regime

(b) Fixed Exchange Regime

Notes: The figure presents impulse responses from a three-variable VAR in log real GDP, the ratio of firm debt to GDP, and
the ratio of household debt to GDP. The solid lines are the responses to a one-percent shock in each variable, and the dashed
lines are 95% confidence intervals computed with the bias-corrected bootstrap.

a small increase in output up to four to five years. The patterns are strikingly different for the
countries with fixed exchange rate regimes, whose results are plotted in the panels on the right.
An increase in output tends to increase household and firm debt. An increase in household
and firm debt leads to a short-term boom in output for two to three years, but sustained lower
output in the medium term from the fourth year on. The fluctuations in output are especially
larger in response to an increase in household debt than to an increase in firm debt.
It is interesting to see that the exchange rate regime affects the dynamic relationship between
debt and output. Both household debt and firm debt decline in the floating exchange rate
countries, but rise in the fixed exchange rate countries, in response to an output shock. In
the floating exchange rate countries, we do not observe a significantly negative implication for
output from a shock to either household debt or firm debt. By contrast, in the fixed exchange
rate countries, a shock to either household debt or firm debt generates large fluctuations in
output: output rises in the short term, but declines substantially in the medium term. The
short-run output booms and the medium-run output slumps are both statistically significant.
Thus, nominal rigidities captured by fixed exchange rates appear to be an important friction
which drives the negative relationship between a shock to either household or firm debt and
future output in the data. In contrast, the baseline model, which does not have nominal
rigidities or frictions, predicts a positive relationship between a debt shock and future output.
21

4.4

Foreign Debt and Output

We next investigate whether the source of financing—domestic or external—matters for the
dynamic relationship between debt and output. To be more specific, we run the VAR regression
with output, domestic debt, and foreign debt. The results are plotted in Figure 8. As shown
in the two upper panels, a positive output shock barely changes the foreign-debt-to-output
ratio over time in both developed and developing countries. By contrast, a positive output
shock lowers the-domestic debt-to-output ratio in both groups in the short and medium run.
The magnitude of the decline in the domestic-debt-to-output ratio is substantially larger in
developed countries than in developing countries: 1.5 versus 0.9 percentage points.
Figure 8: Impulse Responses: Domestic Debt, Foreign Debt, and Output

(a) Developed Countries

(b) Developing Countries

Notes: The figure presents impulse responses from a three-variable VAR in log real GDP, the ratio of domestic debt to GDP,
and the ratio of foreign debt to GDP. The solid lines are the responses to a one-percent shock in each variable, and the dashed
lines are 95% confidence intervals computed with the bias-corrected bootstrap.

Turning to the two lower panels of Figure 8, we observe that a shock to foreign debt tends
to depress subsequent output for many years in both groups of countries. It might not be
surprising that a shock to foreign debt is associated with lower future output in developing
countries. What is surprising is that output is depressed more substantially in response to a
foreign debt shock in the developed countries. The magnitude in the developed countries is
more than twice of that in the developing countries: 0.17 versus 0.07 percent.
External debt is often denominated in a foreign currency, which makes the exchange rate
regime matter for the implications of debt overhang. High levels of foreign debt in countries
with a fixed exchange rate regime exposes those countries to currency crises and severe real
22

contractions. In general, high levels of domestic debt in fixed exchange rate countries are not
associated with these risks. The Asian financial crisis in 1997–1998 is largely the consequence
of the private sector’s high exposure to foreign debt. The Latin American sovereign debt crisis
in the 1980s is an example of the consequence of high external indebtedness in the public sector.
We thus explore the relationship between foreign debt and GDP across different exchange rate
regimes. The results are plotted in Figure 9.
Figure 9: Impulse Responses across Exchange Rate Regimes:
Domestic Debt, Foreign Debt, and Output

(a) Floating Exchange Regime

(b) Fixed Exchange Regime

Note: The figure presents impulse responses from a three-variable VAR in log real GDP, domestic debt to lagged GDP, and net
foreign debt to lagged GDP. The solid lines are the responses to one percent shock in each variable, and the dotted lines are
95% confidence interval by the bias-corrected bootstrap.

In response to a positive output shock, domestic debt decreases and foreign debt increases
in both the fixed and floating exchange rate (see the two upper panels of Figure 9). The decline
in domestic debt is much larger in countries with a fixed exchange rate regime. In the floating
exchange rate countries, a shock to either domestic debt or foreign debt has limited impacts
on future output, just as a shock to household and firm debt. However, in the fixed exchange
rate countries, a shock to foreign debt significantly lowers future output for a sustained period
of time. By the tenth year after the shock, output is 0.22 percent lower than the initial level.
These different implications of holding foreign and domestic debt across exchange rate regimes
show the importance of nominal rigidities or frictions in understanding the negative relationship
between a shock to foreign debt and future output.

23

4.5

Further Empirical Analysis

Consumption and investment are two major components of output. In theory, the impact of a
debt shock on output works through either the investment channel or the consumption channel.6
We examine the implications of debt shocks on consumption and investment dynamics and
compare the patterns across the developed and developing countries. Specifically, we estimate
a VAR in log real consumption (or investment), public debt, firm debt, and household debt.
Figure 10 presents the behavior of consumption and investment in response to positive debt
shocks.
Figure 10: Impulse Responses of Consumption and Investment

(a) Developed Countries

(b) Developing Countries

Notes: The top (bottom) panels present impulse responses from a four-variable VAR in log real consumption (investment),
the ratio of public debt to GDP, the ratio of firm debt to GDP, and the ratio of household debt to GDP. The solid lines are
the responses to a one-percent shock in each variable, and the dashed lines are 95% confidence intervals computed with the
bias-corrected bootstrap.

Let’s first look at the responses of developed countries in the panels on the left of Figure
10. A shock to either firm debt or public debt lowers future consumption and investment,
but the negative impact tends to be small and statistically insignificant. What moves future
consumption and investment is a shock to household debt: countries initially experience consumption and investment booms, and then consumption and investment fall below the trend.
The initial consumption and investment booms are significant and persistent for four years.
The subsequent consumption declines are also significant, while investment declines are not
6
Examples of research on the investment channel include Bernanke and Gertler (1989), Kiyotaki and Moore
(1997), Caballero and Krishnamurthy (2003), Lorenzoni (2008), and Brunnermeier and Sannikov (2014). Mian
et al. (2013) provide empirical support for this channel for the United States during the Great Recession.

24

significant.
Let’s now switch to the impulse responses of the developing countries in the panels on
the right of Figure 10. A public debt shock does not appear to have a negative effect on
consumption or investment. Consumption is not significantly affected by a firm debt shock
either. Investment, however, declines substantially in response to a firm debt shock. The
decline in investment by the fourth year is 1.1 percent and remains significantly negative until
the ninth year. The response patterns of consumption and investment in developing countries to
a household debt shock are qualitatively similar to those in developed countries: initial booms
followed by large declines. Quantitatively, the initial booms are small and not significant, but
the subsequent declines are large and significant. The magnitudes of the declines in consumption
and investment are substantially larger in developing countries than in developed countries. By
the sixth year, consumption drops by 0.77 percent and investment drops by 1.0 percent.
Finally, we conduct robustness analysis on the main empirical findings. First, we check
whether our results, particularly for the developed countries, are driven by the Great Recession.
Specifically, we limit the sample periods up to 2006 and redo the VAR analysis. While we
generally observe qualitatively similar results for developed countries, the estimated coefficients
of the VAR models using substantially shorter time-series observations have wider confidence
intervals. Second, given the large heterogeneity across the developing countries, we separate the
developing sample further into two groups: emerging markets and other developing countries.
We find that the impulse responses are similar across emerging markets and other developing
countries (see the appendix for further details of our analysis).

5

Conclusion

The global economy is at a record high level of indebtedness. The phenomenon of increasing debt
exposure occurs in every economic sector (households, firms, and governments) across the globe.
Often the bust of a debt expansion is associated with severe and enduring real contractions,
where output growth is depressed for many years. Academic researchers and policymakers are
increasingly concerned about the ramifications of the current outstanding debt levels. That
said, not all types of debt are created equal. Different types of debt differ in their implications
for subsequent output growth, which is thoroughly investigated and documented in this paper
for a panel of 72 countries over the period 1970–2014 using VAR analysis. The empirical findings
are useful for further academic research and policy studies.
We document two puzzling findings that run counter to predictions made by the baseline
model by Aguiar and Gopinath (2007). In their model, debt and output endogenously respond
to stochastic TFP shocks without fundamental real or nominal frictions. The first puzzle is that
25

in developing countries total debt falls below the initial level for several years after a positive
output shock, while the model predicts a debt expansion. The other is that output declines
persistently in both developed and developing countries after a debt shock, while the model
predicts sustained higher output. This negative relationship is stronger for developing countries
(than developed countries) and for countries with a fixed exchange regime (than countries with
a floating exchange regime). When probing deeply into different categories of total debt, we
find systematic differences in the relational patterns between debt and output across economic
sectors and financing sources.
These empirical results are broadly consistent with stories of either financial frictions or
nominal rigidities in the literature, which are absent in the baseline model. Particularly, these
frictions are more pronounced in developing countries or countries with a fixed exchange rate
regime. Given the systematic patterns in the relations of output with private and public
debt documented in this paper, it is critical to incorporate both public and private debt in a
quantitative model in the future analysis of this topic.

26

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Appendix
A1. Country Coverage
Table A1: List of Sample Countries
Developed Countries (21)
Australia
Austria
Belgium
Canada
Denmark
Finland
France

Germany
Greece*
Ireland
Italy
Japan
Netherlands
New Zealand

Norway
Portugal
Spain
Sweden
Switzerland
United Kingdom
United States

Developing Countries (51)
Algeria
Argentina*
Bahrain
Bangladesh
Bhutan
Botswana
Brazil*
Cambodia
Chile*
China, Mainland
Croatia
Czech Republic*
Dominican Republic
Ecuador
Egypt*
El Salvador
Estonia

Guatemala
Hungary*
India*
Indonesia*
Iran
Israel
Kazakhstan
Kenya
Korea*
Latvia
Lithuania
Malaysia*
Mexico*
Morocco
Nepal
Oman
Pakistan*

Philippines*
Poland*
Russian Federation*
Saudi Arabia*
Singapore
Slovak Republic
Slovenia
South Africa*
Sri Lanka
St. Lucia
Thailand
Turkey*
United Arab Emirates*
Ukraine
Uruguay
Vanuatu
Venezuela

*: Emerging market countries from the Morgan Stanley Capital International (MSCI) Emerging Markets
Index.

The sample countries are selected by the following procedure. Among the countries with
debt data available, we exclude the top and bottom 1% outliers based on the annual changes
in debt to GDP ratios. Then we remove countries with the coverage of private and public debt
data less than ten consecutive years within our sample period 1970-2014. This leaves us 72
sample countries. We include 21 advanced OECD countries in the developed sample. The rest
are included in the developing sample. Among the OECD countries, Chile, Czech Republic,
Estonia, Hungary, Israel, Korea, Latvia, Lithuania, Poland, Slovak Republic, Slovenia, and
Turkey are kept in the developing sample to be consistent with the developing countries used
31

in the literature. Table A1 shows the list of the sample countries.

A2. Data Sources
National Accounts National accounts data comes from the World Bank’s World Development
Indicators. For output, we use annual data in constant 2010 U.S. dollars for GDP. For consumption and investment, we use household and NIPSH final consumption expenditure, and
gross fixed capital formation, respectively.
Exchange Rate Regime Information about the de facto exchange rate regime comes from
Reinhart and Rogoff (2004), wich was updated in Ilzetzki et al. (2017). “Fixed regimes” are
regimes with no separate legal tender, currency boards, pegs, and narrowly defined horizontal
bands (coarse ERA code 1 from Ilzetzki et al., 2017). “Floating regimes” are regimes with
widely defined horizontal bands, crawling pegs, crawling bands, moving bands, managed floats,
and freely floating regimes (coarse ERA codes 2 to 4).
Private Debt Private debt data comes from the Private Debt, Loans and Securities series in
the IMF’s Global Debt Database. It is defined as total stock of loans and debt securities issued
by households and nonfinancial corporations as a share of lagged GDP.
Public Debt Public debt data comes from the IMF’s Historical Public Debt Database. Public
debt is gross government debt as a share of lagged GDP.
Foreign Debt Foreign debt data comes from the 2016 update of the External Wealth of
Nations Mark II database of Lane and Milesi-Ferretti (2007). Net foreign debt is defined as
total external liabilities minus total external assets as a share of lagged GDP.

A.3 Robustness Checks
This appendix reports the results for robustness checks. First, we check whether our results
are driven by the Great Recession. Specifically, we limit the sample periods up to 2006 and
redo the VAR analysis. The results in the pre-global recession sample are similar to those in
the baseline full sample, even though the responses often become statistically not significant
because of wide confidence bands in the reduced sample. Figure A1 displays the response of
output to positive shocks in private debt and public debt as an illustration.7 In the full sample,
private debt negatively impacts output in both developed and developing countries. In the preglobal recession sample, the negative impact of private debt is much weaker and statistically
not significant. The result for public debt we observe in the full sample still remains in the
pre-global recession sample as well. A positive public debt shock reduces output in developed
countries and raises output in developing countries.
7

The other impulse responses are similar to the full sample case, and thus not reported.

32

Figure A1: Impulse Responses: Pre-Great Recession

(a) Developed Countries

(b) Developing Countries

Notes: The figure presents impulse responses from a three-variable VAR in log real GDP, the ratio of public debt to GDP, and
the ratio of private debt to GDP. The solid lines are the responses to a one-percent shock in each variable, and the dashed lines
are 95% confidence intervals computed with the bias-corrected bootstrap.

Second, given the large heterogeneity across the developing countries, we separate the developing sample further into two groups: emerging markets and other developing countries. The
20 emerging market countries are listed with asterisks within Table A1. Figure A2 compares the
response of output to a positive private and public debt shocks for emerging market countries
and for other developing countries.8 In both groups of countries, output declines in response to
a private debt shock and rises in response to a public debt shock.
Figure A2: Impulse Responses: Emerging Markets versus Other Developing Countries

(a) Emerging Markets

(b) Other Developing

Notes: The figure presents impulse responses from a three-variable VAR in log real GDP, the ratio of public debt to GDP, and
the ratio of private debt to GDP. The solid lines are the responses to a one-percent shock in each variable, and the dashed lines
are 95% confidence intervals computed with the bias-corrected bootstrap.

8
The debt responses to a positive output shock and output responses to the other debt expansions are similar
across emerging markets and other developing countries, and thus not reported.

33