Micro Risks and Pareto Improving Policies with Low Interest Rates

Abstract: We provide sufficient conditions for the feasibility of a Pareto-improving fiscal policy when the risk-free interest rate on government bonds is below the growth rate. We do so in the class of incomplete markets models pioneered by Bewley-Huggett-Aiyagari, but we allow for an arbitrary amount of ex ante heterogeneity in terms of preferences and income risk. We consider both the case of dynamic inefficiency as well as the more plausible case of dynamic efficiency. The key condition is that seigniorage revenue raised by government bonds exceeds the increase in the interest rate times the initial capital stock. The Pareto improving fiscal policies weakly expand every agent’s budget set at every point in time. The policies improve risk sharing and potentially guide the economy to a more efficient level of capital. In simulations, we find that the government must rely on moderate levels of debt issuance along the transition to the new steady state.

Keywords: Government debt; Fiscal policy; Heterogeneous agents;

JEL Classification: D20; E20; H20;

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Bibliographic Information

Provider: Federal Reserve Bank of Minneapolis

Part of Series: Staff Report

Publication Date: 2021-06-28

Number: 625