The Role of Government Debt in a World on Incomplete Financial Markets

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The Role of Government Debt in a World on Incomplete Financial Markets

Author Info

Steven James
Philippe Karam

Abstract

Aiyagari and McGrattan (1998) developed a model in which optimal net government debt in the steady state is positive. This result arises from a particular form of financial market incompleteness: that households cannot buy insurance against prolonged spells of low income. In this paper we extend the Aiyagari-McGrattan model in ways that preserve incomplete financial markets but overturn the result that optimal net government debt is positive. In particular, we show that Aiyagari and McGrattan implicitly assume that government debt crowds out government waste, which provides an additional channel for net debt to provide social benefits. We show that when this channel is blocked, positive net debt is no longer optimal. We also relax the assumption that the economy is closed and show that in an open economy the "insurance" benefit provided by net government debt is diluted by the fact that foreigners will hold some of the debt. In our open economy case positive net debt is again no longer optimal.

Aiyagari et McGrattan (1998) ont établi un modèle dans lequel la dette publique nette optimale, en état stationnaire, est positive. Ce résultat découle d’une forme particulière d’inachèvement des marchés financiers : à savoir que les ménages ne peuvent souscrire de l’assurance contre les périodes prolongées de faible revenu. Dans ce document, nous élargissons le modèle Aiyagari-McGrattan de manière à préserver l’inachèvement des marchés financiers, mais à invalider le résultat selon lequel la dette publique nette optimale est positive. En particulier, nous démontrons que Aiyagari et McGrattan supposent implicitement que la dette publique évince le gaspillage public, ce qui offre une autre voie permettant à la dette nette d’assurer des prestations sociales. Nous démontrons que lorsque cette voie est bloquée, la dette nette positive n’est plus optimale. Nous assouplissons aussi l’hypothèse voulant que l’économie soit fermée, et démontrons que, dans une économie ouverte, l’« assurance » offerte par la dette publique nette est diluée du fait que les étrangers détiendront une certaine partie de cette dette. Dans notre économie ouverte, la dette nette positive n’est plus optimale encore une fois.

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Paper provided by Department of Finance Canada in its series Working Papers-Department of Finance Canada with number 2001-01.

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Handle: RePEc:fca:wpfnca:2001-01

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This paper has been announced in the following NEP Reports:

NEP-ALL-2003-10-28 (All new papers)
NEP-FIN-2003-10-28 (Finance)

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