Aguiar, Mark, Manuel Amador, and Cristina Arellano (2022): “Micro Risks and (Robust) Pareto Improving Policies” (Under revision for American Economic Review)
We provide sufficient conditions for the feasibility of robust Pareto-improving (RPI) fiscal policies when the risk-free interest rate on government bonds is below the growth rate (r<g) or there is a markup between price and marginal cost. We do so in the class of incomplete markets models pioneered by Bewley-Huggett-Aiyagari, but we allow for an arbitrary amount of ex ante heterogeneity in terms of preferences and income risk. An RPI improves risk sharing and potentially guides the economy to a more efficient level of capital. We show that the elasticities of aggregate savings to changes in interest rates are the crucial ingredients that determine the feasibility of RPIs. We establish that government debt and capital investment associated with an RPI may be complements along the transition, rather than the traditional substitutes.