DP17529 Public Debt and the Balance Sheet of the Private Sector
This paper studies the sustainability and distributive effects of fiscal policy in a simple model with incomplete financial markets and heterogeneous agents. The model features households and firms, which face non-insurable idiosyncratic productivity shocks. There is only one financial asset, namely risk free debt, issued by the firms and the government, and bought by households. Higher government debt changes the balance sheet of the private sector by boosting corporate equity, increases the risk free rate r, and reduces the growth rate of output g. It is always optimal to issue government debt and by choosing the appropriate combination of public debt, taxes, and subsidies, the government can implement the constrained social welfare optimum. The weight of firms and their owners in the government's welfare function determines whether r < g or r > g at the optimum. The dynamics of the economy is quite different in these two regimes.