DP17529 Fiscal Policy and the Balance Sheet of the Private Sector
This paper characterizes optimal fiscal policy in a growth model with incomplete markets, heterogeneous agents (households and entrepreneurs), and idiosyncratic productivity risk. Entrepreneurs run risky production, which they cannot finance optimally because of an agency problem. In the second-best optimum, they issue continuously traded bonds. Households invest in private and public debt. The government has to finance an exogenous expenditure flow and maximizes a weighted sum of the welfare of entrepreneurs and households. We show that any constrained Pareto optimal allocation can be decentralized as a competitive equilibrium by issuing an appropriate amount of public debt, combined with suitable wealth taxation.
Positive public expenditure shocks leave the optimal debt-to-GDP ratio unaffected and increase tax rates. Such shocks also determine whether r < g or r > g in equilibrium, with different dynamics and fiscal sustainability in the two regimes.
