Abstract
Several advanced economies are heading towards a period of fiscal stress; aging population raises government transfers which in turn increases nominal government debt. Existing literature studies how alternative combinations of monetary and fiscal policies can stabilize real debt in the face of exponentially rising transfers. This paper develops an overlapping generations (OG) model to study the implications of endogenous labor supply on the path of real government debt under alternative policy regimes and finds that switching to an alternative policy regime where monetary authority is passive in the face of rising transfers, even before the economy is at the fiscal limit, might stabilize inflation better than an active monetary regime. The model in the paper has been calibrated to the US economy to demonstrate dynamic effects.
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