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Need for (the Right) Speed: the Timing and Composition of Public Debt Deleveraging

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  • Romei, Federica

Abstract

This paper studies the optimal path for public debt deleveraging in a heterogeneous agents framework under incomplete financial markets. My analysis addresses two questions. What is the optimal fiscal instrument the government needs to use to reduce public debt? What is the optimal speed of public debt deleveraging? The main finding is that public debt should be reduced quickly and by cutting public expenditure. If the fiscal authority is forced to use income taxation instead, public debt deleveraging needs to be slow. Independently of fiscal instruments, the economy may end up in a liquidity trap. I show that, in my model, the zero lower bound has a redistributive effect. If the liquidity trap is very persistent, it can reallocate resources from financially constrained agents to financially unconstrained ones. Due to this mechanism, a very slow public debt reduction achieved by increasing income taxation is very costly in terms of aggregate welfare.

Suggested Citation

  • Romei, Federica, 2015. "Need for (the Right) Speed: the Timing and Composition of Public Debt Deleveraging," Economics Working Papers MWP2015/11, European University Institute.
  • Handle: RePEc:eui:euiwps:mwp2015/11
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    References listed on IDEAS

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    1. Adam, Klaus & Billi, Roberto M., 2006. "Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 38(7), pages 1877-1905, October.
    2. Adam, Klaus & Billi, Roberto M., 2007. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Journal of Monetary Economics, Elsevier, vol. 54(3), pages 728-752, April.
    3. Luca Fornaro, 2018. "International Debt Deleveraging," Journal of the European Economic Association, European Economic Association, vol. 16(5), pages 1394-1432.
    4. Pierpaolo Benigno & Gauti B. Eggertsson & Federica Romei, 2020. "Dynamic Debt Deleveraging and Optimal Monetary Policy," American Economic Journal: Macroeconomics, American Economic Association, vol. 12(2), pages 310-350, April.
    5. Benigno, Pierpaolo & Romei, Federica, 2014. "Debt deleveraging and the exchange rate," Journal of International Economics, Elsevier, vol. 93(1), pages 1-16.
    6. Carroll, Christopher D., 2006. "The method of endogenous gridpoints for solving dynamic stochastic optimization problems," Economics Letters, Elsevier, vol. 91(3), pages 312-320, June.
    7. Röhrs, Sigrid & Winter, Christoph, 2017. "Reducing government debt in the presence of inequality," Journal of Economic Dynamics and Control, Elsevier, vol. 82(C), pages 1-20.
    8. Frank Smets & Raf Wouters, 2003. "An Estimated Dynamic Stochastic General Equilibrium Model of the Euro Area," Journal of the European Economic Association, MIT Press, vol. 1(5), pages 1123-1175, September.
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    Cited by:

    1. 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.
    2. Ralph Luetticke, 2018. "Transmission of Monetary Policy with Heterogeneity in Household Portfolios," Discussion Papers 1819, Centre for Macroeconomics (CFM).
    3. Javier Andres & Oscar Arce & Dominik Thaler & Carlos Thomas, 2020. "When Fiscal Consolidation Meets Private Deleveraging," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 37, pages 214-233, July.
    4. Fonseca, Miguel, 2020. "Fiscal Consolidations: Welfare Effects of the Adjustment Speed," MPRA Paper 98902, University Library of Munich, Germany, revised 02 Mar 2020.
    5. Axelle Ferriere & Anastasios G. Karantounias, 2019. "Fiscal Austerity in Ambiguous Times," American Economic Journal: Macroeconomics, American Economic Association, vol. 11(1), pages 89-131, January.
    6. Thomas Philippon & Francisco Roldán, 2018. "On the Optimal Speed of Sovereign Deleveraging with Precautionary Savings," IMF Economic Review, Palgrave Macmillan;International Monetary Fund, vol. 66(2), pages 375-413, June.
    7. Grancini, Stefano, 2021. "Risk Aversion and Fiscal Consolidation Programs," MPRA Paper 105500, University Library of Munich, Germany.

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    Keywords

    Fiscal policy; Heterogeneous agents; Public debt deleveraging;
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