Demonstration effect and dynamic efficiency

- I show that the dynamic inefficiency arising in a standard Diamond (1965) economy can be cured using the demonstration-effect approach popularized by Cox and Stark (2005).
- Family transfers are positive if there is dynamic inefficiency. There exists a saddle path that converges to a steady state in which the capital stock can be made arbitrarily close to the Golden Rule one.
- However, family transfers are nil under dynamic ​efficiency. Unlike public debt, both capital accumulation and welfare are not worsened.

Can dynamic inefficiency be remedied by intergenerational family transfers? The issue matters for the connection between fiscal policy and economic growth. Yet family transfers have mostly been narrowly cast as altruistic. I show that an alternative motive-the demonstration effect, whereby parents transfer to mold preferences of children-can generate vastly different results: family transfers are positive under dynamic inefficiency. These transfers are instrumental to depress capital accumulation so as to approach the Golden Rule capital stock. Intuitively, family transfers from youth to old age reduce capital accumulation. However, family transfers are nil under dynamic efficiency. Unlike public debt, both capital accumulation and welfare are not worsened.