Dotting i's and Crossing t's with Respect to Olivier Blanchard's "Secular Stagnation" Fiscal-Policy-in-an-Era-of-Low-Interest-Rates AEA Presidential Address
Consider the semi-canonical Diamond (1965) overlapping-generations model, with a wedge between the safe government-bond interest and the risky profit rate driven by risk aversion. Blanchard (2018) shows that the effects of increased debt have two effects that:
- raise (lower) reprentative-agent utility,
- evaluated after the resolution of uncertainties when the agent is young:
- a direct-transfer effect that holds when the safe government-bond rate is lower (higher) than the economy's growth rate, and
- a factor-price effect that holds when the risky average profit rate is lower (higher) than the economy's growth rate.
Robert Waldmann has convinced me that this second factor-price effect can be neutralized by a balanced-budget profit tax-funded wage subsidy.
Hence in the semi-canonical Diamond (1965) overlapping-generations model the economy is dynamically-inefficient—can be made better off by reducing its productive capital stock and introducing sustainable pay-as-you-go transfer schemes—whenever the safe government-bond rate is less than the economy's growth rate, no matter what the level of the expected profit rate:
There are a lot of other issues Blanchard considers, or that I think should be considered. In my estimation of their rough order of importance:
Where does the wedge between the Treasury interest rate and the average profit rate come from, and what are the implications of that wedge's origins?
How and why does the average profit rate overestimate or underestimate the societal returns from investing in capital?
What are the risks that interest rates will spike?
What are the possibilities for using financial repression to control interest rate spikes?
How does the level of the debt affect the possibilities for multiple equilibria?
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