Welfare Analysis of Debt Policy during Recessions

Abstract

This paper develops an overlapping-generations model with nominal wage rigidities and examines the welfare effects of debt policy when unemployment exists. Issues of public debt stimulate aggregate consumption demand and create employment. Future generations then face both increased wage incomes and higher taxes. If the amount of outstanding bonds is already large, debt policy deteriorates the welfare of future generations by levying heavy taxes. By contrast, if the outstanding bond issue is relatively small, debt policy can be Pareto improving by creating more employment. Therefore, the welfare implications of debt policy during recessions can be discriminated from those during booms.