Individual Essay - Normative Evaluation of Debt in A Neoclassical OLG Model
Individual Essay - Normative Evaluation of Debt in A Neoclassical OLG Model
Individual Essay - Normative Evaluation of Debt in A Neoclassical OLG Model
Macroeconomics
2016/2017
Author:
Daniel Abreu, No. 43759
1
NORMATIVE EVALUATION OF DEBT IN A NEOCLASSICAL OLG MODEL
objective is to describe each paper and emphasize the contribution of the latter
model. The main insight provided by the application of Khule’s method is that
the variation in utility during the transition path and in the steady state may
differ in sign.
1. INTRODUCTION
The overlapping-generations models (OLG) models have been a powerful theoretical tool
objective of this essay is twofold: first, to do a short description of Diamond (1965) and
Kuhle (2014) papers; second, to highlight how the latter complements the seminal paper.
My interest in economic growth motivated the choice of the articles studied in this essay.
In the second and third section I examine Diamond (1965) and Khule (2014) papers,
respectively. In the fourth section I make a brief comment regarding the relation between
The main results of this paper are that the competitive equilibrium may not be optimum
and that the utility of the individuals is negatively affected by the introduction of debt.
For comparison purposes with Kuhle (2014) I will focus on the second main conclusion.
The Diamond model states that output at time t , ( Yt ), is produced combining capital stock
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Daniel S. Abreu Normative evaluation of debt 2
scale, it is subject to diminishing marginal product in relation to both inputs and satisfies
the Inada conditions. The intensive form is given by yt f (kt ) . Population grows at rate
n . Markets are assumed to be competitive and consequently the real interest rate is given
The individuals live for two periods, they are born and work in the first and are retired
and die in the second. Another important aspect is the assumption that people are not
altruistic about the utility of their descendants. Let e1 and e2 denote the consumption in
the first and second period respectively, so that the individual utility function is given by
U (e1 , e2 ) . These individuals allocate their wages between present and future consumption
equilibrium condition relates the interest rate to the wage rate of the previous period,
Constant returns to the production function implies that there is a relation between the
marginal products of labor and capital. This relation is named factor price frontier and is
1
Is assumed that the elasticity of saving in respect to the interest rate is small enough that an
increase in saving results in a lower interest rate.
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Daniel S. Abreu Normative evaluation of debt 3
rate in period t 1 depends on the wage rate in period t . Hence, we can write rt 1 ( wt )
. Using these two expressions, it is possible to trace the entire path of an economy given
some initial values for w and r . Due to the assumption of normality2 the economy will
reach a single, stable equilibrium. The interest rate resulting from this equilibrium may
be lower than n , therefore the competitive solution may not be efficient. In order to keep
this text simple I will only consider the efficient case, where r n .
The major question analyzed is the long-run impact in the utility of individuals caused by
the substitution of taxes for debt, in order to finance a given expenditure level.
Introducing external debt implies a decrease in saving because the younger generation
has to pay for the interest costs not covered by the increased debt. Assuming that debt
grows at the rate n , so that the external debt-labor ratio, g1 , is constant, the real wage
rate must be rewritten as t wt (rt n) g1 . The real wage rate must be modified to
rt 1 ( ) . Combining the curve (that is unchanged) with the new curve will imply
a higher interest rate in the long run. Thus, the introduction of external debt moves the
economy away from the gold rule solution3. The utility of the different individuals that
populate this economy over time will be lower due to three effects: i) the decrease in the
real wage; ii) the progressive increase in the tax burden due to the successive increases in
the interest rate; iii) Decrease in the utility from factor payments. In the case of internal
debt, g 2 , the supply side of the capital market is affected in the same manner as with
2
0 s / w 1
3
The Golden rule states that the optimum level of consumption for every period is achieved when r n
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Daniel S. Abreu Normative evaluation of debt 4
external debt. But now, the government enters on the demand side of the capital market
and thus part of the saving will be used to buy government’s debt instead of being used
discussion follows that exchanging external debt for internal debt results in a decrease in
In this paper the author develops a method to characterize the changes in utility along the
transition path to a new steady state in the OLG model. The framework used by the author
U t U (kt , kt 1 ; b) . Making these alterations the author derives two prepositions that
dU 1 U 1
(1)
db b
dU U t 1 U U
db kt i 0
k (k ; b)i b (k ; b)
k t 1
k ( k ; b ) t b ( k ; b )
b
(2)
A B
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Daniel S. Abreu Normative evaluation of debt 5
dU ss U t U 1 U
lim b ( k ; b) (3)
db t b k 1 k (k ; b) b
With these expressions it is possible to describe the total impact of a change in b in the
utility of the cohorts that populate the model in the adjustment period. Part A of equation
(2) represents the cumulative change in capital, part B reflects the incremental effect and
U / b the direct effect. Equation (3) describes the effects that occur only at the steady
state.
In order to perform this exercise we introduce a constant debt to labor ratio in the same
fashion as described in section 2.3.1. This ratio will be represented as the exogenous
dU t t 1 1 1 n
U c1 (r n) ki b (k b) f ''(k ) 1 U c1 (k b) f ''(k ) kt b (4)
db i 0 1 r 1 r
Setting t we obtain
dU ss 1 1
U c1 (r n) b (k b) f ''(k ) 1 (5)
db 1 k 1 r
These expressions allow the author to read three additional prepositions: Preposition 3
states that if r n (in which the competitive solution is inefficient) the increase in the
debt to labor ratio would improve utility for all future cohorts. Additionally, if the speed
of convergence of the capital stock is high and the difference n r is small, the short-run
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Daniel S. Abreu Normative evaluation of debt 6
gains are larger in comparison to long-run gains. Intuitively, the decrease in saving causes
an increase in the interest rate, as a result the lower capital to labor ratio will permit a
higher level of consumption in each period after the introduction of debt. Preposition 4
1 n
( k b) f ''(k ) kT b
r n 1 r for T 0 (6)
i 0 k b
T 1 i
( k b ) f ''( k )
1
1 r
1
the increased rate of return will have a positive effect on the utility of the following
generations. However, due to the increase in taxes, these effects are diminishing.
Eventually they will become negative in the transition path and consequently in the new
if the transition path is sufficiently close to the golden rule and if | r n | , any change
Kuhle (214) provides important insights regarding the utility of the cohorts that live
during the (infinite) time span between the old and new steady state and thus contributes
to the analysis of the total effects of debt in utility. Considering the prepositions derived
in section 3.2, there can be made three additional comments about the introduction of debt
and its implications: first, the effects on utility during the transition path differ in
magnitude from those in the steady-state and they can actually differ in sign. For me this
individuals living during the time of the marginal increase in the size of debt may not be
aligned with those of the future cohorts, thus implying that there is a true intergenerational
problem; second, in the seminal paper the effects of debt in the long-run utility crucially
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depend upon the efficiency of the competitive solution. From the discussion made in the
previous section, we were able to understand the importance of the difference between
the equilibrium interest rate (prior to any variation of the debt to labor ratio) and the
golden rule, n ; Third, the importance of the capital market is highlighted. The speed of
convergence of the capital stock and the nature of this market contributes to enhance
5. CONCLUSIONS
The complete evaluation of the introduction of debt in a neoclassical OLG model requires
the results from both papers examined in this essay. Diamond argued the introduction of
national debt reduces the utility of the individual living in the long-run equilibrium.
Additionally, it is shown that the substitution of internal debt for external debt reduces
utility. Both results require that the competitive solution is efficient. Khule derives the
necessary mathematical expressions to study the dynamics of utility along the transition
path to a new steady state. The main insight provided by the application of this method
to the Diamond (1965) economy is that the variation in utility in the transition path and
REFERENCES
Kuhle, W. (2014). The dynamics of utility in the neoclassical OLG model. Journal of