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Optimal Public Debt with Life Cycle Motives

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  • William B. Peterman
  • Erick Sager

Abstract

This paper determines optimal public debt in a life cycle model with incomplete markets that matches the empirically observed variation in consumption, labor, and savings. We find that public savings—not public debt—equal to 168 percent of output is optimal, primarily due to the influence of the life cycle on household decision-making. By inducing a lower interest rate, public savings slow consumption and leisure growth over an average household's lifetime, and the resulting flatter allocation of lifetime consumption and leisure improves welfare. These life cycle welfare benefits are large—on net, they outweigh the transitional costs from a tax-financed public debt elimination.

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  • William B. Peterman & Erick Sager, 2022. "Optimal Public Debt with Life Cycle Motives," American Economic Journal: Macroeconomics, American Economic Association, vol. 14(4), pages 404-437, October.
  • Handle: RePEc:aea:aejmac:v:14:y:2022:i:4:p:404-37
    DOI: 10.1257/mac.20180247
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    Cited by:

    1. Patrick Macnamara & Myroslav Pidkuyko & Raffaele Rossi, 2022. "Taxing Consumption in Unequal Economies," Economics Discussion Paper Series 2210, Economics, The University of Manchester.
    2. Blandin, Adam & Peterman, William B., 2019. "Taxing capital? The importance of how human capital is accumulated," European Economic Review, Elsevier, vol. 119(C), pages 482-508.
    3. Hedlund, Aaron, 2018. "Credit constraints, house prices, and the impact of life cycle dynamics," Economics Letters, Elsevier, vol. 171(C), pages 202-207.
    4. Pedro Brinca & Miguel H. Ferreira & Francesco Franco & Hans A. Holter & Laurence Malafry, 2021. "Fiscal Consolidation Programs And Income Inequality," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 62(1), pages 405-460, February.
    5. Pedro Brinca & Hans Holter & Miguel Faria-e-Castro & Miguel Ferreira, 2019. "The Nonlinear Effects of Fiscal Policy," 2019 Meeting Papers 934, Society for Economic Dynamics.
    6. Bettoni, Luis G. & Santos, Marcelo, 2023. "Optimal fiscal policy in incomplete market business cycle economies," The Quarterly Review of Economics and Finance, Elsevier, vol. 89(C), pages 218-226.
    7. Gale, William G., 2019. "Fiscal policy with high debt and low interest rates," MPRA Paper 99207, University Library of Munich, Germany.
    8. Zuzana Mucka & Ludovit Odor, 2018. "Optimal sovereign debt: Case of Slovakia," Working Papers Working Paper No. 3/2018, Council for Budget Responsibility.
    9. Aaron Hedlund, 2018. "Credit Constraints, House Prices, and the Impact of Life Cycle Dynamics," Working Papers 1807, Department of Economics, University of Missouri.

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    More about this item

    JEL classification:

    • D15 - Microeconomics - - Household Behavior - - - Intertemporal Household Choice; Life Cycle Models and Saving
    • D52 - Microeconomics - - General Equilibrium and Disequilibrium - - - Incomplete Markets
    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • G51 - Financial Economics - - Household Finance - - - Household Savings, Borrowing, Debt, and Wealth
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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