Torsten Persson | Macro Paper Warehouse

Deficits and intergenerational welfare in open economies

Persson extends Diamond’s (1965) overlapping-generations model of public debt to open economies, asking how a one-time, debt-financed tax cut to the currently young generation redistributes welfare across generations once the economy can borrow and lend internationally. In a small open economy facing a fixed world interest rate, the paper shows that the familiar closed-economy conclusion survives but sharpens: the generation receiving the tax cut still gains (though by less, since there is no domestic interest-rate rise to further raise its return on savings), but now every later generation is unambiguously worse off in the new steady state, removing an ambiguity that is present for the generation immediately following the deficit in the closed-economy case. The paper also traces out the current-account dynamics of this experiment, showing that a single period of government budget deficit sets off a short sequence of current-account deficits — in the small open economy, the adjustment to the new, permanently higher external debt is complete just two periods after the initial deficit. When the analysis is extended to a full two-country world equilibrium, the result changes qualitatively: because a home-country deficit now raises the common world interest rate, the home country’s future generations are no longer necessarily burdened — if the country ends up a net external creditor, the resulting terms-of-trade gain can redistribute enough income from the rest of the world that future generations are actually better off, even though total world welfare still declines unambiguously.

Real Transfers in Fixed Exchange Rate Systems and the International Adjustment Mechanism

This 1984 Journal of Monetary Economics paper by Torsten Persson (circulated as IIES Seminar Paper No. 237, February 1983) asks whether the “monetary approach to the balance of payments” (MABOP) prediction – that a monetary expansion in a country produces a balance-of-payments deficit together with higher real spending in that same country – actually holds once the institutional details of how a fixed exchange rate is defended are modeled explicitly. Building a two-country, infinite-horizon, perfect-foresight general-equilibrium model with an explicit transactions role for money, the paper compares three regimes for defending a fixed parity: stabilization with interest-bearing reserves, stabilization with non-interest-bearing reserves (or, equivalently, a classical gold standard), and a cooperative “exchange rate union” in which the two monetary authorities finance each other’s interventions without any claims arising between them. The central result is that real variables are completely insulated from monetary disturbances when reserves are interest-bearing, but not otherwise: with non-interest-bearing reserves or an exchange-rate union there is an inherent transfer of purchasing power between the two countries, and a worked two-period example shows this transfer can run in the opposite direction from what the MABOP predicts – a monetary expansion in the “home” country can lower home real spending and welfare and raise them abroad, even though home still runs the bigger balance-of-payments deficit.