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The Theory of Optimum Deficits and Debt

  • Willem H. Buiter

The paper surveys a number of neo-classical and neo-Keynesian approcaches to government financial policy. After reviewing the very restrictive conditions under which financial policy is just a veil without real consequences, non-neutral financial policy in neo-classical models is analyzed. At full employment, the substitution of borrowing for lump sum taxes crowds outprivate capital formation in a closed economy.Government financial policy can be used to implement optimal intertemporal risk distribution schemes. In the presence of distortionary taxes, the smoothing of tax rates over time may be optimal even where this involves systematic and predictable departures from continuous budget balance. The case for deficit finance and the operation of the automatic fiscal stabilizers in a Keynesian world with disequilibrium in labour and output markets is restated.The case for any kind of active financial policy rests on the presence of capital market imperfections (including incomplete contingent forward markets such as insurance markets), on the longevity of the institution of government and on the government's unique ability to tax. Finally, certain long-run aspects of the fiscal and monetary stance are analyzed. This includes their sustainability, i.e. the consistency of long-term spending and taxation plans with the monetary objectives and the crowding outtargets. The concepts of the comprehensive net worth of the public sector and its permanent income are central to this analysis. The current U.K. position appears to be one of an unsustainable, "permanent surplus."

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1232.

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Date of creation: Nov 1983
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Publication status: published as Buiter, Willem H. "The Theory of Optimum Deficits and Debt." The Economics of Large Government Deficits. Federal Reserve Bank of Boston Conference Series Number 27. (October 1983)
Handle: RePEc:nbr:nberwo:1232
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  1. Barro, Robert J., 1974. "Are Government Bonds Net Wealth?," Scholarly Articles 3451399, Harvard University Department of Economics.
  2. Willem H. Buiter, 1981. "The Superiority of Contingent Rules over Fixed Rules in Models with Rational Expectations," NBER Technical Working Papers 0009, National Bureau of Economic Research, Inc.
  3. Robert J. Barro, 1981. "On the Predictability of Tax-Rate Changes," NBER Working Papers 0636, National Bureau of Economic Research, Inc.
  4. Laurence Weiss, 1978. "The Role for Active Monetary Policy in a Rational Expectations Model," Cowles Foundation Discussion Papers 491, Cowles Foundation for Research in Economics, Yale University.
  5. Webb, David C, 1981. "The Net Wealth Effect of Government Bonds When Credit Markets are Imperfect," Economic Journal, Royal Economic Society, vol. 91(362), pages 405-14, June.
  6. Finn Kydland & Edward C. Prescott, 1980. "A Competitive Theory of Fluctuations and the Feasibility and Desirability of Stabilization Policy," NBER Chapters, in: Rational Expectations and Economic Policy, pages 169-198 National Bureau of Economic Research, Inc.
  7. Siegel, Jeremy J, 1979. "Inflation-Induced Distortions in Government and Private Saving Statistics," The Review of Economics and Statistics, MIT Press, vol. 61(1), pages 83-90, February.
  8. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-71, October.
  9. Willem H. Buiter, 1983. "Deficits, Crowding Out and Inflation: The Simple Analytics," NBER Working Papers 1078, National Bureau of Economic Research, Inc.
  10. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  11. Sandmo, Agnar, 1974. "A Note on the Structure of Optimal Taxation," American Economic Review, American Economic Association, vol. 64(4), pages 701-06, September.
  12. Joseph E. Stiglitz, 1983. "On the Relevance or Irrelevance of Public Financial Policy," NBER Working Papers 1057, National Bureau of Economic Research, Inc.
  13. Sadka, Efraim, 1977. "A theorem on uniform taxation," Journal of Public Economics, Elsevier, vol. 7(3), pages 387-391, June.
  14. Carmichael, Jeffrey, 1982. "On Barro's Theorem of Debt Neutrality: The Irrelevance of Net Wealth," American Economic Review, American Economic Association, vol. 72(1), pages 202-13, March.
  15. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  16. Turnovsky, Stephen J, 1980. "The Choice of Monetary Instrument under Alternative Forms of Price Expectations," The Manchester School of Economic & Social Studies, University of Manchester, vol. 48(1), pages 39-62, March.
  17. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-87, December.
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