Optimal Fiscal Policy with Incomplete Markets
Posted: 17 Feb 2005
Date Written: October 2004
Abstract
This paper studies optimal fiscal policy in an economy with heterogeneous households and incomplete markets. Relative to a representative-agent version of the model, the Ramsey planner takes into account the idiosyncratic income risk faced by heterogeneous households in a way that alters the model's prediction about the government debt level. The simpler model with a representative agent has the government accumulate assets that eventually give it such large interest earnings that it can finance its budget with zero taxes. In contrast, with heterogeneous agents who face income risk that is sufficiently large relative to government expenditure risk, the Ramsey planner chooses to issue debt and facilitate self-insurance of the private sector. I interpret these outcomes in terms of the strengths of two competing precautionary saving motives that concern the Ramsey planner: the precautionary saving of households, and of the government.
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