Debt, Pensions and Fiscal Policy under Dynamic Inefficiency and Demographic Change

Abstract

New evidence suggests that the criterion for dynamic efficiency is not verified for any advanced economy and that over-accumulation of capital may in fact be an issue. This thesis uses a 2-period overlapping generations model with public debt and an endogenous interest rate to study how dynamic inefficiency should optimally be dealt with. The analyses reveal that a pay-as-you-go pension scheme and public debt mitigate dynamic inefficiency. A specific policy mix is required to guide a dynamically inefficient economy characterised by a high debt level towards the welfare maximising Golden Rule growth path. It is demonstrated that this policy mix must comprise of an increase in pay-as-you-go pension contributions and a reduction in the governmental primary budget deficit. In face of the ongoing increase in the dependency ratio, economies suffering from over-accumulation of capital achieve higher welfare levels enforcing a defined benefit pay-as-you-go pension scheme rather than a defined contribution pay-as-you-go pension scheme.