Government Debt and Private Investing under Loss Aversion∗

How does government debt financing affect the risk structure of private invest-ment projects? I address this question in an equilibrium model in the presence of non-insurable labor income risk. Individuals are assumed to be loss averse. I find that, as long as debt financing is not excessively high, high-risk investments increase with the size of the deficit. Thus, a moderate level of debt financing should be expected to promote investments in risky research and development activities and therefore be beneficial for economic growth. Key words: Market for riskless bonds; low-risk/high-risk investments; loss aversion; behavioral macroeconomics