Working Paper: CEPR ID: DP14440
Authors: Sushant Acharya; Keshav Dogra
Abstract: We present an incomplete markets model to understand the costs and benefits of increasing government debt when an increased demand for safety pushes the natural rate of interest below zero. A higher demand for safety widens spreads, causing the ZLB to bind and increasing unemployment. Higher government debt satiates the demand for safe assets, raising the natural rate, and restoring full employment. This entails permanently lower investment which reduces welfare, since our economy is dynamically efficient even when the natural rate is negative. Despite this, increasing debt is optimal if alternative instruments are unavailable. Alternative policies which permit negative real interest rates - higher inflation targets, negative nominal rates - achieve full employment without reducing investment.
Keywords: safe assets; negative natural rate; crowding out; risk premium; liquidity traps
JEL Codes: E3; E4; E5; G1; H6
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| increased demand for safety (J28) | natural rate of interest below zero (E43) |
| natural rate of interest below zero (E43) | widening of spreads (G19) |
| widening of spreads (G19) | zero lower bound (ZLB) binds (E43) |
| zero lower bound (ZLB) binds (E43) | increased unemployment (J65) |
| higher government debt (H63) | satisfies demand for safe assets (E41) |
| satisfies demand for safe assets (E41) | raises natural rate (E43) |
| raises natural rate (E43) | restores full employment (J68) |
| higher government debt (H63) | permanently lower investment (G31) |
| permanently lower investment (G31) | negatively impacts welfare (I30) |
| policies allowing for negative real interest rates (E43) | achieve full employment (J68) |
| policies allowing for negative real interest rates (E43) | does not reduce investment (G31) |