Time-Inconsistent Optimal Quantity of Debt

YiLi Chien and Yi Wen

No 2020-037, Working Papers from Federal Reserve Bank of St. Louis

Abstract: A key property of the Aiyagari-type heterogeneous-agent models is that the equilibrium interest rate of public debt lies below the time discount rate. This fundamental property, however, implies that the Ramsey planner’s fiscal policy may be time-inconsistent because the forward-looking planner would have a dominant incentive to issue plenty of debt such that all households are fully self-insured against idiosyncratic risk. But such a full self-insurance allocation may be paradoxical because, to achieve it, the optimal labor tax rate may approach 100% and aggregate consumption may approach zero. This is puzzling from an intuitive perspective because near the point of full self-insurance the marginal gains of increasing debt should be less than the marginal costs of financing the debt under distortionary taxes. We show that this puzzling behavior originates from the assumption that the planner must commit to future plans at time zero. Under such a full commitment, the Ramsey planner opts to exploit the low interest cost of borrowing to front-load consumption by sacrificing future consumption in the long run because future utilities are heavily discounted compared to the inverse of the interest rate on government bonds. We demonstrate our points analytically using a tractable heterogeneous-agents model featuring non-linear preferences and a well-defined distribution of household wealth.

Keywords: Time Inconsistency; Optimal Debt; Ramsey Problem; Incomplete Markets (search for similar items in EconPapers)
JEL-codes: E13 E62 H21 H30 (search for similar items in EconPapers)
Pages: 49 pages
Date: 2020-10-29, Revised 2021-09-02
New Economics Papers: this item is included in nep-dge, nep-mac, nep-pub and nep-upt
Note: Publisher DOI: https://doi.org/10.1016/j.euroecorev.2021.103913
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Citations: View citations in EconPapers (3)

Published in European Economic Review

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DOI: 10.20955/wp.2020.037

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