Government Debt Dynamics Under Discretion

Abstract:     
This paper studies the dynamics of state-contingent government debt in the case that the fiscal authority cannot commit to a policy in the future. Under commitment, optimal policy calls for letting debt follow a stationary process and take values that depend on the initial outstanding liabilities. In contrast, in the case that the fiscal authority lacks the ability to commit, it modifies its policy tools, i.e. the tax rates and government spending, to lower the intertemporal price of consumption goods available in the current period, i.e. the real interest rate, with the aim of lowering the intertemporal value of its current outstanding liabilities. Over time, this drives government debt and the economy toward a region where no policy action by the fiscal authority can lower the real interest rate any longer.

Number of Pages in PDF File: 17

Keywords: Commitment, Time-consistency, Ramsey equilibrium, Markov perfect equilibrium

JEL Classification: E62

working papers series