A Ramsey Theory of Low Interest Rates

Marco Bassetto and Wei Cui

No 729, 2019 Meeting Papers from Society for Economic Dynamics

Abstract: Berndt, Lustig, and Yeltekin (2012) document that a large fraction of fiscal shocks are absorbed neither by taxes nor by an immediate drop in the value of government debt, but rather by continuing low rates of return in the years following the shock. This is similar to the findings documented by Reinhart and Sbrancia (2015). From the perspective of standard models of optimal taxation, this finding is puzzling: typically, the government should finance such shocks either through immediate contingent taxes, or by previously-issued state-contingent debt, or by increasing labor taxes, with only minor effects arising from intertemporal distortions. We study how this answer changes in the presence of financial frictions such that the entrepreneurs' net worth has a direct effect on their ability to invest. In this case, such net worth is affected by the government policy through changes in intertemporal prices. A new trade-off emerges between pursuing policies that relax the financial constraints and those that minimize the distortions of financing government spending, providing a potential avenue to reconcile the empirical findings with the theory.

Date: 2019
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Persistent link: https://EconPapers.repec.org/RePEc:red:sed019:729

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