THE OPTIMUM QUANTITY OF DEBT

We find that the welfare gains to being at the optimum quantity of deb t rather than the current US level are small, and, therefore, concerns regarding the high level of debt in the US economy may be misplaced. This finding is based on a model of a large number of infinitely lived households whose saving behavior is influenced by precautionary savin g motives and borrowing constraints. This model incorporates a differe nt role for government debt than is found in standard models, and it c aptures different cost-benefit trade-offs. On the benefit side, govern ment debt enhances the liquidity off households by providing an additi onal means of smoothing consumption and by effectively loosening borro wing constraints. On the cost side, the implied taxes have adverse wea lth distribution and incentive effects. In addition, government debt c rowds out capital via higher interest rates and lowers per capita cons umption. (C) 1998 Elsevier Science B.V. All rights reserved.