Pareto Improving Fiscal and Monetary Policies: Samuelson in the New Keynesian Model

Abstract

This paper explores the positive and normative consequences of government bond issuances in a New Keynesian model with heterogeneous agents, focusing on how the stock of government bonds affects the cross-sectional allocation of resources in the spirit of Samuelson (1958).We characterize the Pareto optimal levels of government bonds and the associated monetary policy adjustments that should accompany Pareto-improving bond issuances.The paper introduces a simple phase diagram to analyze the global equilibrium dynamics of inflation, interest rates, and labor earnings in response to changes in the stock of government debt.The framework also provides a tractable tool to explore the use of fiscal policy to escape the Effective Lower Bound (ELB) on nominal interest rates and the resolution of the "forward guidance puzzle." A common theme throughout is that following the monetary policy guidance from the standard Ricardian framework leads to excess fluctuations in income and inflation.

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