Cristina Arellano - Federal Reserve Bank of Minneapolis

Micro Risks and (Robust) Pareto Improving Policies

Abstract

We provide sufficient conditions for the feasibility of robust Pareto-improving (RPI) fiscal policies in the class of incomplete markets models of Bewley-Huggett-Aiyagari and when the interest rate on government debt is below the growth rate (r < g). We allow for arbitrary heterogeneity in preferences and income risk and a potential wedge between the return to capital and to government bonds. An RPI improves risk sharing and can induce a more efficient level of capital. We show that the elasticities of aggregate savings to changes in interest rates are the crucial ingredients that determine the feasibility of RPIs. We establish that government debt and capital investment associated with an RPI may be complements along the transition, rather than the traditional substitutes. Our analysis shifts the focus of fiscal policy in incomplete markets from explicitly redistributive policies to using government bonds and simple subsidies to robustly improve welfare of all agents at all points in time.

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