Running primary deficits forever in a dynamically efficient economy: feasibility and optimality

Abstract: Government debt can be rolled over forever without primary surpluses in some stochastic economies, including some economies that are dynamically efficient. In an overlapping-generations model with constant growth rate, g, of labor-augmenting productivity, and with shocks to the durability of capital, we show that along a balanced growth path, the maximum sustainable ratio of bonds to capital is attained when the risk-free interest rate, rf , equals g. Furthermore, this maximal ratio maximizes utility per capita along a balanced growth path and ensures that the economy is dynamically efficient.