Endogenous labor supply and Diamond's (1965) model: a reconsideration of the debt role

this paper we show that, when elastic labor supply is considered via Cobb Douglas preferences, dynamic inefficiency of OLG economies, while being still a necessary condition, is no longer sufficient for an internal public debt increase to generate a Pareto improvement. This is due to the fact that the equilibrium interest rate can move in the "wrong" direction due to the reaction of labor supply. Consequently, raising the level of debt when the economy is experiencing dynamic inefficiency could even be welfare-worsening, in contrast with Diamond (1965).