Debt Management and Optimal Fiscal Policy with Long Bonds
London Business School
Universitat Autònoma de Barcelona - Institut d'Anàlisi Economica CSIC
affiliation not provided to SSRN
BIS Paper No. 65k
We study Ramsey optimal fiscal policy under incomplete markets in the case where the government issues only long bonds of maturity N > 1. We find that many features of optimal policy are sensitive to the introduction of long bonds, in particular tax variability and the long-run behaviour of debt. When government is indebted, it is optimal to respond to an adverse shock by promising to reduce taxes in the distant future as this achieves a cut in the cost of debt. Hence, debt management concerns override typical fiscal policy concerns such as tax-smoothing. In the case where the government leaves bonds in the market until maturity, we find two additional reasons why taxes are volatile due to debt management concerns: debt has to be brought to zero in the long run and there are N -period cycles. We formulate our equilibrium recursively applying the Lagrangean approach for recursive contracts. However even with this approach the dimension of the state vector is very large. To overcome this issue we propose a flexible numerical method, the “condensed PEA”, which substantially reduces the required state space. This technique has a wide range of applications. To explore issues of policy coordination and commitment we propose an alternative model where monetary and fiscal authorities are independent.
Full publication: Threat of fiscal dominance? http://ssrn.com/abstract=2078895
Number of Pages in PDF File: 36
Keywords: Computational methods, debt management, fiscal policy, government debt, maturity structure, tax-smoothing, yield curve
JEL Classification: C63, E43, E62, H63Accepted Paper Series
Date posted: June 12, 2012
© 2013 Social Science Electronic Publishing, Inc. All Rights Reserved.
This page was processed by apollo8 in 0.328 seconds