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Micro Risks and Pareto Improving Policies

Staff Report 625 | Revised August 30, 2021

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Authors

Mark Aguiar Consultant
Manuel Amador Monetary Advisor
Cristina Arellano Assistant Director, Policy and Monetary Advisor
Micro Risks and Pareto Improving Policies

Abstract

We provide sufficient conditions for the feasibility of a Pareto-improving fiscal policy when the risk-free interest rate on government bonds is below the growth rate (_r < g_) or there is a markup between price and marginal cost. We do so in the class of incomplete markets models pioneered by Bewley-Huggett-Aiyagari, but we allow for an arbitrary amount of ex ante heterogeneity in terms of preferences and income risk. We consider both the case of dynamic inefficiency as well as the more plausible case of dynamic efficiency. The key condition is that seigniorage revenue raised by government bonds exceeds the increase in the interest rate times the initial capital stock. The Pareto improving fiscal policies weakly expand every agent's budget set at every point in time. The policies improve risk sharing and potentially guide the economy to a more efficient level of capital. We establish that debt and investment associated with Pareto improving policies along the transition may be complements, rather than the traditional substitutes.


This paper previously circulated with the title _Micro Risks and Pareto Improving Policies with Low Interest Rates_.