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.