Governmental debt, interest policy, and tax stabilization in a stochastic OLG economy

The paper analyzes the sustainability of governmental debt and its welfare properties in an overlapping generations economy with stochastic production and capital accumulation. In the absence of taxation, equilibria with positive debt generically converge to debtless eauilibria are typically inefficient. It is shown that this may be overcome by a tax on labor income which stabilizes the level of debt against unfavorable shocks. A long-run welfare criterion is formulated which measures consumer utility at the stabilized equlibrium. Based on this criterion, the welfare effects of different interest policies and alternative stabilization objectives are investigated. The results offer a simple explanation why empirical debt levels are high and typically yield a riskless return despite both fails to be optimal in the long run.