Public Debt, the Terms of Trade and Welfare in an Overlapping Generations Model with Lifetime Uncertainty

Abstract

This article reconsiders the relationship between government debt and welfare in a two-country overlapping-generations model with lifetime uncertainty and international product differentiation. It has recently been proposed that a higher steady-state debt level may be welfare-enhancing in this setting. It is pointed out that this proposition does not adequately account for the effect of debt policy on individual agents' intertemporal consumption profiles. While a higher debt may indeed raise aggregate steady-state consumption, the lifetime utility of all steady-state cohorts will actually drop, unless the elasticity of substitution between domestic output and imports is extremely low. These particular results illustrate a more general caveat pertaining to any normative policy analysis in settings with overlapping generations of intertemporally optimizing agents: Attempts to draw welfare inferences on the basis of comparisons of aggregate consumption paths can be misleading.

Keywords: Overlapping generations, lifetime uncertainty, perpetual youth model, debt, welfare, terms of trade, intertemporal choice

JEL Classification: H6, E6, D9, F41