Public debt and aggregate risk

Abstract

This paper assesses the long-run optimal level of public debt in a non Ricardian framework with aggregate fluctuations. Households are subject to aggregate and idiosyncratic risk, face borrowing constraints and the incompleteness of markets prevents them from perfectly insuring against risk. We find that aggregate fluctuations modify the cost and the motive for precautionary saving. Higher levels of public debt, by effectively reducing the cost of precautionary saving, help agents to smooth consumption when they face price and employment fluctuations. The longrun optimal level of public debt is higher in an economy with aggregate fluctuations than in an economy without.

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