Reducing Public Debt under Dynamic Efficiency: Transitional Dynamics in Diamond's OLG Model

Fiscal retrenchment is on the political agenda in the U.S. as well as in the EU. Utilizing Diamond's [1965] classic OLG growth model with internal debt, this paper focuses on temporarily adjusting the ratio of the primary budget surplus to GDP to achieve a target debt to GDP ratio lower than its initial level in the case of dynamic efficiency. The transitional dynamics of the debt to GDP and of the capital–output ratios are rigorously analyzed. It is shown that reducing the public debt to GDP ratio diminishes private capital intensity too.The author thanks, without implication, an anonymous referee and Laurie Conway for extremely useful advice and comments.