Public Debt Bubbles in Heterogeneous Agent Models with Tail Risk

Abstract

This paper studies the public debt implications of a class of Aiyagari (1994)-Bewley (1977)-Huggett (1993) (ABH) models of incomplete insurance in which agents face a near-zero probability of a highly adverse outcome. In generic models of this kind, there exists a public debt bubble, so that the government is able to borrow at a real interest rate that is perpetually below the economic growth rate. Given an equilibrium with a public debt bubble, the primary deficit and the level of debt are both strictly increasing in the real interest rate and in the fraction of government expenditures used for lumpsum transfers. There is no upper bound on the deficit level or long-run debt level that is sustainable in equilibrium. In a public debt bubble, regardless of its size, agents are better off in the long run if the government chooses policies that give rise to a larger debt and primary deficit.