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Public Debt Bubbles in Heterogeneous Agent Models with Tail Risk

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  • Narayana R. Kocherlakota

Abstract

This paper studies the public debt implications of a class of Aiyagari (1994)-Bewley (1977)-Huggett (1993) (ABH) models of incomplete insurance in which agents face a near-zero probability of a highly adverse outcome. In generic models of this kind, there exists a public debt bubble, so that the government is able to borrow at a real interest rate that is perpetually below the economic growth rate. Given an equilibrium with a public debt bubble, the primary deficit and the level of debt are both strictly increasing in the real interest rate and in the fraction of government expenditures used for lumpsum transfers. There is no upper bound on the deficit level or long-run debt level that is sustainable in equilibrium. In a public debt bubble, regardless of its size, agents are better off in the long run if the government chooses policies that give rise to a larger debt and primary deficit.

Suggested Citation

  • Narayana R. Kocherlakota, 2021. "Public Debt Bubbles in Heterogeneous Agent Models with Tail Risk," NBER Working Papers 29138, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:29138
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    Cited by:

    1. Zhengyang Jiang & Hanno Lustig & Stijn Van Nieuwerburgh & Mindy Z. Xiaolan, 2024. "What Drives Variation in the U.S. Debt‐to‐Output Ratio? The Dogs that Did not Bark," Journal of Finance, American Finance Association, vol. 79(4), pages 2603-2665, August.
    2. Andrew B. Abel & Stavros Panageas, 2025. "Running Primary Deficits Forever in a Dynamically Efficient Economy: Feasibility and Optimality," Econometrica, Econometric Society, vol. 93(5), pages 1601-1633, September.
    3. Lenel, Moritz, 2022. "Comment on “The supply and demand for safe assets”," Journal of Monetary Economics, Elsevier, vol. 125(C), pages 148-150.
    4. Masataka Eguchi & Toshiya Hatano, 2023. "What is fiscal sustainability?―Transversality condition, Domar condition, the fiscal theory of the price level―," Public Policy Review, Policy Research Institute, Ministry of Finance Japan, vol. 19(3), pages 1-29, September.
    5. Ricardo Reis, 2021. "The constraint on public debt when r," Discussion Papers 2111, Centre for Macroeconomics (CFM).
    6. Kocherlakota, Narayana R., 2022. "Stabilization with fiscal policy," Journal of Monetary Economics, Elsevier, vol. 131(C), pages 1-14.
    7. Mark Aguiar & Manuel Amador & Cristina Arellano, 2021. "Micro Risks and Pareto Improving Policies," Working Papers 2021-15, Princeton University. Economics Department..
    8. Narayana R. Kocherlakota, 2023. "Infinite Debt Rollover in Stochastic Economies," Econometrica, Econometric Society, vol. 91(5), pages 1629-1658, September.
    9. Tomohiro Hirano & Alexis Akira Toda, 2025. "Bubble Necessity Theorem," Journal of Political Economy, University of Chicago Press, vol. 133(1), pages 111-145.
    10. Atif Mian & Ludwig Straub & Amir Sufi, 2021. "A Goldilocks Theory of Fiscal Policy," Working Papers 2021-37, Princeton University. Economics Department..
    11. Osband, Kent & Filoso, Valerio & Capasso, Salvatore, 2024. "The limits of limitless debt," Journal of Macroeconomics, Elsevier, vol. 79(C).
    12. Ricardo Reis, 2021. "The constraint on public dept when r," BIS Working Papers 939, Bank for International Settlements.

    More about this item

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • H62 - Public Economics - - National Budget, Deficit, and Debt - - - Deficit; Surplus
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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