Working Paper: CEPR ID: DP17529
Authors: Hans Gersbach; Jean Charles Rochet; Ernst Ludwig von Thadden
Abstract: This paper characterizes optimal fiscal policy in a growth model with incomplete markets, heterogeneous agents (households and entrepreneurs), and idiosyncratic productivity risk. Entrepreneurs run risky production, which they cannot finance optimally because of an agency problem. In the second-best optimum, they issue continuously traded bonds. Households invest in private and public debt. The government has to finance an exogenous expenditure flow and maximizes a weighted sum of the welfare of entrepreneurs and households. We show that any constrained Pareto optimal allocation can be decentralized as a competitive equilibrium by issuing an appropriate amount of public debt, combined with suitable wealth taxation.Positive public expenditure shocks leave the optimal debt-to-GDP ratio unaffected and increase tax rates. Such shocks also determine whether r < g or r > g in equilibrium, with different dynamics and fiscal sustainability in the two regimes.
Keywords: incomplete financial markets; debt; interest; growth; ponzi games; heterogeneous agents
JEL Codes: E44; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| more government debt (H63) | reduces corporate leverage (G32) |
| more government debt (H63) | increases the risk-free rate (r) (E43) |
| more government debt (H63) | decreases the growth rate (g) (O40) |
| public debt (H63) | growth rate (g) (O40) |
| appropriate combination of public debt and taxes (H69) | constrained social welfare optimum (D69) |
| weight of firms in government’s welfare function (D69) | r > g or r < g (C29) |