Meets Bewley: Optimal Government Financing with Incomplete Markets

This paper studies optimal fiscal policy in an economy with heterogeneous households and incomplete markets. Relative to a representative-agent version of the model, the Ramsey planner takes into account the idiosyncratic income risk faced by heterogeneous households in a way that alters the model’s prediction about the level of government debt. The simpler model with a representative agent has the government accumulate assets to minimize tax distortion in the long run. In contrast, with heterogeneous agents who face undiversifiable idiosyncratic risk that is sufficiently large relative to aggregate risk, the Ramsey planner chooses to issue debt and facilitate the precautionary saving of the private sector, even at the cost of extra tax distortion. I interpret these outcomes in terms of the strengths of two competing insurance motives that concern the Ramsey planner: aggregate tax smoothing and individual consumption smoothing