Public debt and aggregate risk

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