Involuntary Unemployment, Inflexible Aggregate Investment, and Limits to Public Debt

Abstract

It is the aim of this chapter to investigate the question of whether limits to public debt exist in a “Old-Keynesian”-like intertemporal equilibrium model of involuntary unemployment. As well-known, there is still no consensus among macro-economists about the general equilibrium foundations of Keynes’ [1] concept of involuntary unemployment in a perfectly functioning market economy. While macro-economists agree that involuntary unemployment is traced back to a lack of aggregate demand (aggregate demand failures), they are still divided about the reasons for aggregate demand remaining below full-employment output. A majority adhering to the New Keynesian approach of micro-founded, dynamic general equilibrium models refers aggregate demand failures back to sticky prices sluggishly adapting to market imbalances due to adjustment costs and imperfect competition (for a survey of earlier contributions Dixon [2] and for the more recent dynamic stochastic general equilibrium (DSGE) models [3], and Woodford [4]). A minority of general-equilibrium oriented macro-economists trace aggregate demand failures back to inflexible aggregate investment which does not passively adapt to aggregate savings even though prices clear perfectly competitive markets [5] and Magnani [6]. While Magnani [6] incorporated inflexible aggregate investment in Solow’s [7] growth model, in this chapter involuntary unemployment and inflexible aggregate investment are modeled in a Diamond [8]-type overlapping generations (OLG) economy with production, physical and human capital accumulation and public debt in line with Farmer and Kuplen [9] and Farmer [10]. This model is used to investigate the question of whether in the face of involuntary unemployment, limits to public debt can and/or ought to be respected, or simply disregarded. It is found that limits to public debt to output ratios exist; and their numerical values are calculated. Moreover, a debt threshold pops up whereby larger public debt diminishes output growth. In fact, the numerical value of the debt threshold is found to be close to World Bank estimates. While these results are comforting, the problem of micro-foundations for inflexible aggregate investment remains open. Two promising approaches to solve this problem are shortly reviewed at the end.