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Public debt and aggregate risk

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    Abstract

    This paper assesses the optimal level of public debt in a new framework where aggregate fluctuations are taken into account. Agents are subject to both aggregate and idiosyncratic shocks and the market structure prevents them from perfectly insuring against the risk. We find that the optimal level of debt is very different when aggregate risk is taken into account : a simple idiosyncratic model generates a quarterly optimal level of debt of 60 % of GDP, our benchmark model embedding aggregate risk finds the quarterly optimal level of debt to be 180 % of GDP, our benchmark model embedding aggregate risk finds the quarterly optimal level of debt to be 180 % of GDP. Thus aggregate fluctuations have a strong positive impact on the level of public debt in the economy. Aggregate fluctuations exacerbate the overall risk level in the economy and households are forced to increase their precautionary saving in response. Public debt and the implied higher interest rate generate a strong effect that helps precautionary saving behavior.

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    File URL: ftp://mse.univ-paris1.fr/pub/mse/CES2007/V07042.pdf
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    Bibliographic Info

    Paper provided by Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne in its series Documents de travail du Centre d'Economie de la Sorbonne with number v07042.

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    Length: 32 pages
    Date of creation: Sep 2007
    Date of revision:
    Handle: RePEc:mse:cesdoc:v07042

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    Keywords: debt; aggregate risk; precautionary saving.;

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    Cited by:
    1. Petia Topalova & Dan Nyberg, 2010. "What Level of Public Debt Could India Target?," IMF Working Papers 10/7, International Monetary Fund.
    2. Zhang, Yuewen, 2010. "Sovereign Risk Management in Recession: The Cases of Sweden and China," MPRA Paper 23364, University Library of Munich, Germany.

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