Are Government Bonds Net Wealth?

This 1974 Journal of Political Economy paper by Robert Barro asks whether an increase in government bonds raises households’ perceived net wealth, and argues that within an overlapping-generations model with physical capital, government debt has no marginal net-wealth effect – and hence no effect on aggregate demand or interest rates – so long as current generations are connected to future generations by an operative chain of intergenerational transfers, in either direction. Using a Samuelson-Diamond two-period overlapping-generations framework in which each generation’s utility depends on its own consumption and on the attainable utility of its immediate descendant, Barro shows that when the solution for bequests (or, symmetrically, gifts from young to old) is interior, a marginal bond issue financed by future lump-sum taxes on the next generation is exactly offset by an adjustment in the size of the bequest, leaving every generation’s consumption and utility unchanged; this result survives the introduction of proportional inheritance taxation (so long as some transfers remain operative) but breaks down, in the direction of the standard Modigliani (1961) wealth effect, once households are pinned at a corner with zero bequests, and turns negative once positive transaction costs for bond issuance and tax collection are introduced. The paper then relaxes the assumption of a single discount rate: if government bond issue effects a loan from low-discount-rate to high-discount-rate (credit-constrained) individuals, a net-wealth effect appears only insofar as the government intermediates this loan more efficiently than private capital markets can, and this effect vanishes at the margin once debt issuance is carried to the point of eliminating that efficiency gap. A parallel argument covers government debt’s nonpecuniary “liquidity services”: the marginal net-wealth effect is zero if government acts as a competitive producer of these services, positive if it under-produces them monopolistically, and negative if it over-produces them. Finally, considering the risk composition of household balance sheets, Barro argues that once the associated tax liabilities are properly netted out, the sign of any risk effect from government debt is ambiguous, depending on whether relative tax liabilities are correlated with relative income and on the transaction costs of private versus public risk-pooling. The paper’s overall conclusion is that there is no persuasive a priori theoretical case for treating government debt as a component of household net wealth at the margin – the case for a negative wealth effect is, Barro argues, as strong a priori as the case for a positive one – with far-reaching implications for the Metzler-type nonneutrality of money, the effect of debt on capital formation, and the effectiveness of tax-versus-debt-financed fiscal policy.

Rules, discretion and reputation in a model of monetary policy

This 1983 Journal of Monetary Economics paper by Robert Barro and David Gordon shows that a monetary authority acting with full discretion each period will generate more inflation on average than one bound by a fixed rule, because private agents rationally anticipate the policymaker’s temptation to spring inflation surprises and build that expectation into wages and prices, so the surprises never systematically materialize and only the extra average inflation remains. The model gives the policymaker a per-period cost, z = (a/2)π² - b(π - π^e), that is increasing and convex in realized inflation π but falls with a positive inflation shock (π - π^e), where the benefit parameter b (varying randomly with mean b̄) captures gains such as reducing unemployment below a distorted natural rate or extracting revenue by depreciating the real value of nominally denominated money and government debt. Under discretion the policymaker minimizes expected cost taking expectations as given, yielding π̂ = b̄/a and, in rational-expectations equilibrium, π^e = π̂, so inflation shocks average zero but expected cost is strictly higher than under the “ideal rule” of zero inflation, which would eliminate the inflation term entirely; that ideal rule, however, is generally not enforceable, because if people expect zero inflation the policymaker’s one-period temptation to cheat, (1/2)(b̄)²/a, exceeds the enforcement available from the mere threat of losing credibility for one period, (1/2)q(b̄)²/a (with q the discount factor, necessarily less than one). The paper’s central extension is to reputational equilibria: given a postulated expectations mechanism under which the private sector reverts to discretionary expectations for one period after any policy violation and then restores trust, the best rule the policymaker can credibly sustain is the constant-inflation rate π* = (b̄/a)(1-q)/(1+q), which is a weighted average of the ideal rule and the discretionary outcome, moving toward discretion as the discount factor falls (e.g., during wars) and toward the ideal rule as it rises. When the benefit parameter and discount factor are instead observed before inflation is set, the best enforceable contingent rule has the policymaker “bite the bullet” with surprisingly low (even negative) inflation when the benefit parameter is low, investing in credibility that is cashed in as surprisingly high, welfare-improving inflation when the benefit parameter is high (e.g., during a war or recession). The authors note their results depend on assuming a fixed one-period punishment interval and flag that varying this interval generates a family of reputational equilibria among which the model, as developed, cannot select.

Robert J. Barro | Macro Paper Warehouse

Are Government Bonds Net Wealth?

Rules, discretion and reputation in a model of monetary policy