On Friday 28 April, the European University Institute hosted the ADEMU seminar Macroeconomic stabilization, monetary-fiscal interactions, and Europe’s monetary union, with William B.Peterman (Federal Reserve Board of Governors).
Building on the findings of a seminal paper by Aiyagari and McGrattan (1998) (in a standard incomplete markets model with infinitely lived agents it is optimal for the U.S. government to hold a large amount of public debt and it is optimal for the U.S. government to hold a large amount of public debt) William Peterman will discuss the way he has revisited such results in a life cycle model to find that public debt’s insurance enhancing mechanism is severely limited. In fact, while a higher interest rate encourages higher average savings in both models, the benefits vary. In a life cycle model, agents enter the economy with no savings but must accumulate the higher level of savings throughout their lifetime, thereby eliminating some of the benefits. In contrast, infinitely lived agents do not accumulate savings over a lifetime and, thus, simply enjoy the benefit of the higher average savings ex ante. Overall, the new research shows that while optimal debt is equal to 22% of output in the infinitely lived agent model, when a life cycle is introduced it is optimal for the government to hold savings equal to 59% of output. Not accounting for life cycle features when computing optimal policy reduces welfare by nearly one-half percent of expected lifetime consumption.
The full text of the paper that was presented is available here.