Working Paper Revision

The Determination of Public Debt under both Aggregate and Idiosyncratic Uncertainty

Abstract: We use an analytically tractable, heterogeneous-agent incomplete-markets model to show that the Ramsey planner’s decision to finance stochastic public expenditures implies a departure from tax smoothing and an endogeneous mean-reverting force to support positive debt growth despite the government’s precautionary saving motives. Specifically, the government’s attempt to balance the competing incentives between its own precautionary saving (tax smoothing) and households’ precautionary saving (individual consumption smoothing)—even at the cost of extra tax distortion—implies an endogenous, soft lower bound on the stochastic unit-root dynamics of optimal taxes and public debt, thus making the ad hoc debt limits imposed by Aiyagari, Marcet, Sargent, and Seppala (2002) unnecessary.

Keywords: Ramsey Problem; Tax Smoothing; Optimal Public Debt; Incomplete Markets;

JEL Classification: E13; E62; H21; H30;

https://doi.org/10.20955/wp.2019.038

Status: Published in Journal of Economic Theory

Bibliographic Information

Provider: Federal Reserve Bank of St. Louis

Part of Series: Working Papers

Publication Date: 2021-12-29

Number: 2019-038

Note: Publisher DOI: https://doi.org/10.1016/j.jet.2022.105474

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