"Optimal Fiscal Policy in an Economy with Private Borrowing Limits"
Publication type: Working paper
This paper develops a theory of public debt management in which some house-holds cannot borrow. We consider a constant aggregate endowment economy in which the government finances exogenous stochastic public spending shocks with uniform lump sum taxes and state-contingent public debt. Households are heterogeneous with respect to their constant endowment. 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 trade-off by limiting the supply of public debt. Consequently, policies and allocations respond persistently to spending shocks along the equilibrium path even though state-contingent debt is available and taxes are lump sum. This is because house-holds 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.
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