Optimal Debt Management and Redistribution

Pierre Yared

No 109, 2009 Meeting Papers from Society for Economic Dynamics

Abstract: This paper develops a theory of debt management in which government financing decisions have distributional consequences. We consider a constant aggregate endowment economy in which the government finances exogenous stochastic public spending needs with uniform lump sum taxes and state-contingent public debt. Households are heterogeneous with respect to their constant endowment and their access to private credit. Ricardian Equivalence holds if public debt is high but not if it is low since some households are borrowing constrained and public debt is traded at a premium. For low levels of debt, tax as opposed to debt financing raises current inequality but reduces future inequality since returns to savers decline. We show that optimal policy exploits this tradeoff by limiting the supply of public debt. Consequently, policies and allocations respond persistently to spending shocks along the equilibrium path even though debt markets are complete and taxes are lump sum. This is because households respond to government policy by saving into the future to protect themselves against borrowing constraints. Nonetheless, in the long run, borrowing constrained households accumulate enough wealth that allocations do not respond persistently to spending shocks and Ricardian Equivalence holds.

Date: 2009
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed009:109

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