Optimal Public Debt Redux

Abstract

We examine the role played by government investment in infrastructure in determining the optimal quantity of public debt in a heterogeneous agent economy with incomplete insurance markets. Calibrating our model to the key aggregate and distributional moments of the U.S. economy, we show that, (i) the inclusion of infrastructure, and (ii) transitional dynamics between stationary states critically affects the characterization of the optimal level of public debt. Welfare comparisons between stationary equilibria indicate that it is optimal for the government to accumulate assets (public surplus). However, once transitional dynamics are accounted for, the optimal share of public debt turns out to be positive and close to the current level of public debt in the U.S. These contrasting results underscore a previously ignored channel through which public investment and tax policies can generate differential trade-offs for the precautionary savings motive for households in the short run and long run. Our results also indicate that the inclusion of public infrastructure in the model specification implies a lower level of optimal debt relative to the model without infrastructure, both when comparing steady states as well as accounting for transitional dynamics.