The Marginal Cost of Funds from

Public Sector Borrowing

Bev Dahlby
Department of Economics
University of Alberta
Edmonton Alberta
Canada, T6G 2H4
bev.dahlby@ualberta.ca

(Revised September, 2004)

Abstract
An expression for the welfare cost of a marginal increase in the public debt is
derived using a simple AK endogenous growth model. This measure of the
marginal cost of public funds (MCF) can be interpreted as the marginal benefit-
cost ratio that a debtfinanced public project needs in order to generate a net social
gain. The model predicts an increase in the public debt ratio will have little effect
on the optimal public expenditure ratio and that most of the adjustment will occur
on the tax side of the budget.

I would like to thank Ergete Ferede, Doug Hostland, Liqun Liu, Tiff Macklem,
Max Nikitin, Chris Ragan, Todd Smith, and Bill Watson for their comments on an
earlier draft of this paper. The financial support of the Donner-Canadian
Foundation for my research on the marginal cost of public funds is gratefully
acknowledged.

Keywords: public debt, crowding out, marginal cost of public funds, endogenous
growth

JEL classifications: E6, H6