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Debt Stabilization in a Non-Ricardian Economy

Author

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  • Simon Wren-Lewis
  • Campbell Leith and Ioana Moldovan

Abstract

In models with a representative infinitely lived household, modern versions of tax smoothing imply that the steady-state of government debt should follow a random walk. This is unlikely to be the case in OLG economies, where the equilibrium interest rate may differ from the policy-maker's rate of time preference such that it may be optimal to reduce debt today to reduce distortionary taxation in the future. Moreover, the level of the capital stock (and therefore output and consumption) in these economies is likely to be sub-optimally low, and reducing government debt will 'crowd in' additional capital. Using an elaborated version of the model of perpetual youth developed by Blanchard (1985) and Yaari (1985), we derive the optimal steady state level of government assets. We show how and why this level of government assets falls short of the level of debt that achieves the optimal capital stock and the level that eliminates income taxes.

Suggested Citation

  • Simon Wren-Lewis & Campbell Leith and Ioana Moldovan, 2011. "Debt Stabilization in a Non-Ricardian Economy," Economics Series Working Papers 542, University of Oxford, Department of Economics.
  • Handle: RePEc:oxf:wpaper:542
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    File URL: http://www.economics.ox.ac.uk/materials/working_papers/paper542.pdf
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    References listed on IDEAS

    as
    1. Campbell Leith & Simon Wren‐Lewis, 2013. "Fiscal Sustainability in a New Keynesian Model," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(8), pages 1477-1516, December.
    2. Agresti, Anna Maria & Mojon, Benoît, 2001. "Some stylised facts on the euro area business cycle," Working Paper Series 0095, European Central Bank.
    3. Leeper, Eric M., 1991. "Equilibria under 'active' and 'passive' monetary and fiscal policies," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 129-147, February.
    4. Andres Erosa & Martin Gervais, 2001. "Optimal taxation in infinitely-lived agent and overlapping generations models : a review," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 23-44.
    5. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-971, October.
    6. Calvo, Guillermo A & Obstfeld, Maurice, 1988. "Optimal Time-Consistent Fiscal Policy with Finite Lifetimes," Econometrica, Econometric Society, vol. 56(2), pages 411-432, March.
    7. Leith, Campbell & Wren-Lewis, Simon, 2011. "Discretionary policy in a monetary union with sovereign debt," European Economic Review, Elsevier, vol. 55(1), pages 93-117, January.
    8. Michael Woodford, 1996. "Control of the Public Debt: A Requirement for Price Stability?," NBER Working Papers 5684, National Bureau of Economic Research, Inc.
    9. Leith, Campbell & Malley, Jim, 2005. "Estimated general equilibrium models for the evaluation of monetary policy in the US and Europe," European Economic Review, Elsevier, vol. 49(8), pages 2137-2159, November.
    10. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
    11. Ascari, Guido & Rankin, Neil, 2007. "Perpetual youth and endogenous labor supply: A problem and a possible solution," Journal of Macroeconomics, Elsevier, vol. 29(4), pages 708-723, December.
    12. Chamley, Christophe, 1986. "Optimal Taxation of Capital Income in General Equilibrium with Infinite Lives," Econometrica, Econometric Society, vol. 54(3), pages 607-622, May.
    13. Leith, Campbell & Wren-Lewis, Simon, 2000. "Interactions between Monetary and Fiscal Policy Rules," Economic Journal, Royal Economic Society, vol. 110(462), pages 93-108, March.
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. The long run government debt target
      by Mainly Macro in Mainly Macro on 2013-01-12 00:11:00
    2. Optimal Debt Policy for Ireland (Warning: Wonkish)
      by John McHale in The Irish Economy on 2013-02-13 04:22:43

    Citations

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    Cited by:

    1. Donal Smith, 2015. "Collateral Constraints and the Interest Rate," Discussion Papers 15/22, Department of Economics, University of York.
    2. Jonathan Portes & Simon Wren-Lewis, 2015. "Issues in the Design of Fiscal Policy Rules," Manchester School, University of Manchester, vol. 83, pages 56-86, September.
    3. Ovalle, Raul & Ramírez, Francisco A., 2014. "Reglas versus Discreción en la Política Fiscal: Introducción al caso Dominicano
      [Rules vs Discretion in Fiscal Policy: An Introduction to the Case of the Dominican Republic]
      ," MPRA Paper 68332, University Library of Munich, Germany.

    More about this item

    Keywords

    Non-Ricardian consumers; Macroeconomic stability; Distortionary taxes;

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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