Factor-biased public capital and private capital crowding out

This paper studies the dynamic effects of public investment on private capital accumulation in a general equilibrium macroeconomic model of a small open economy with factor-biased public capital. I show that public investment induces rather complex private capital dynamics—falling in the short and in the long run, but potentially increasing along transition—if public capital augments private capital and private inputs are gross complements in production. Whether private investment is crowded in or out during transition critically depends on parameters that are empirically hard to measure, such as the labor supply elasticity and the elasticity of substitution between private inputs—a small increase in the latter from 0.5 to 0.6, for instance, turns a totally negative transitional effect into a predominantly positive one. These results help rationalize the lack of empirical consensus on the relationship between public and private investment.