Masters in Applied Econometrics and Forecasting

Macroeconomics

2016/2017

NORMATIVE EVALUATION OF DEBT IN A NEOCLASSICAL OLG MODEL

Author:
Daniel Abreu, No. 43759

ISEG, 31 December 2016

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 NORMATIVE EVALUATION OF DEBT IN A NEOCLASSICAL OLG MODEL

By Daniel Sebastião Abreu

In this essay I examine two articles: Diamond (1965) and Kuhle (2014). My

objective is to describe each paper and emphasize the contribution of the latter

to the analysis of the impact of debt on utility in a neoclassical OLG growth

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

to analyze intergenerational problems such as debt or social security systems. The

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 articles. The last section concludes.

2. DIAMOND (1965): NATIONAL DEBT IN A NEOCLASSICAL GROWTH MODEL

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.

2.1 COMPETITIVE FRAMEWORK

The Diamond model states that output at time t , ( Yt ), is produced combining capital stock

( K t ) and labor ( Lt ). The production function, Yt  F ( Kt , Lt ) , has constant returns to

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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

by r  f '(k ) and the real wage rate is w  f (k )  kf '(k ) .

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

in order to maximize U (e1 , e2 ) , subject to e1  e2 / (1  n)  y  nk . In period t , the

representative individual of this economy receives a wage, wt , consumes e1 and saves

st  wt  e1 . In period t  1 , he will consume his savings and the additional interest,

et21  (1  rt 1 ) st . Thus, the savings can be expressed as, st  s ( wt , rt 1 ) . The sum of

individual savings St  Lt s( wt , rt 1 ) 1 consists on the supply curve of capital. The demand

curve of capital is a function of the capital-labor ratio, rt 1  f '( Kt 1 / Lt 1 ) . The

equilibrium condition relates the interest rate to the wage rate of the previous period,

rt 1  f '( St 1 , Lt 1 )  f '( s( wt , rt 1 ) / (1  n)) .

2.2 THE DYNAMICS OF THE ECONOMY

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

represented by w   (r ) with slope equal to k   s / (1  r ) . We know that the interest

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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 .

2.3 INTRODUCING DEBT

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.

2.3.1 EXTERNAL AND INTERNAL DEBT

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

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0  s / w  1
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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

to rent capital, St  Kt 1  Gt 1 thus having a detrimental effect on output. From this

discussion follows that exchanging external debt for internal debt results in a decrease in

the utility of the individuals.

3. KUHLE (2014): THE DYNAMICS OF UTILITY IN THE NEOCLASSICAL OLG MODEL

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

is the same as the one described in section 2.1 and 2.2.

3.1 MAIN RESULTS

Consider the law of motion of the capital stock

(1  n)kt 1  s( f (kt )  f '(kt )kt , f '(kt 1 ))  0 which can be written as kt 1   (kt ) . To

evaluate policy changes through an exogenous variable, b , we must rewrite this

expression as kt 1   (kt ; b) . Similarly, the individual utility function is changed to

U t  U (kt , kt 1 ; b) . Making these alterations the author derives two prepositions that

constitute the main results of the paper, which I reproduce below.

“Proposition 1. If the economy is initially in a monotonically stable steady state, a

marginal change in the exogenous parameter b which is enacted in period 0 changes

utility of a cohort born in period t  1 according to”

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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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.

“Proposition 2. A marginal change in b , at a locally stable steady state, increases utility

for all cohorts born in t  0 if dU 0 / db  0 , and dU ss / db  0 . If dU 0 / db  0 and

dU ss / db  0 , it reduces utility for all cohorts along the transition path.”

3.2 APPLICATION TO THE DIAMOND MODEL WITH DEBT

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

variable b . The calculation of the coefficients in equation (2) yields

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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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

reveals that if r  n and

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

steady state. Considering a stable Marshallian economy, it is showed in preposition 5 that

if the transition path is sufficiently close to the golden rule and if | r  n |  , any change

in b results in a lower utility for every generation.

4. THE COMPLEMENTARY NATURE OF THE TWO PAPERS

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

is an important result, it constitutes theoretical evidence that the interests of the

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

short-run variations of utility.

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

in the long run equilibrium can differ in sign.

REFERENCES

Diamond, P. A. (1965). National debt in a neoclassical growth model. The American

Economic Review, 55(5), 1126-1150.

Kuhle, W. (2014). The dynamics of utility in the neoclassical OLG model. Journal of

Mathematical Economics, 52, 81-86.