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: