Research Discussion Paper – RDP 8002 Sub-optimality in a Dynamic Economy with Overlapping Generations


Since the time of Adam Smith, belief in the capitalist system of free enterprise has been firmly based on the principle that what is good for the individual is good for the economy – by acting in their own interests, individuals and firms help the whole system to function efficiently. This has left a tenuous toehold for government policy to raise economic efficiency. For example, distribution motives aside, the theory of fiscal policy relies on distortions and externalities to justify intervention on the grounds of efficiency. But what of government financial policy? It has been argued by some that the welfare gains of a monetary economy derive purely from the existence of money, not from its quantity or behaviour over time – a drop is as efficient as an ocean. If such is the case then there can be no role on efficiency grounds for discretionary financial policy (and I include the choice of one stable money supply growth rule over another in my definition of discretionary).

This paper addresses the question of efficiency in a decentralised economy in a dynamic situation. It is well-known that a static decentralised economy is allocatively efficient, but can we say the same of a growing economy in which intertemporal considerations play an important role? This paper argues that in fact there is no natural tendency for such an economy to approach an efficient growth path. The source of the inefficiency is that physical capital is forced to serve two functions: as a productive factor, and as a means of saving. The optimal stock of capital for one function need not coincide with that for the other. This result establishes a prima facie case for government financial policy to play a role in generating economic efficiency over time. A more detailed examination of how policy may achieve this end is to be the subject of future papers in this area.