Debt and Deficit Fluctuations and the Structure of Bond Markets

Abstract

The aim of this paper is to test for the extent of incompleteness in the market for U.S government debt. We show that when a government pursues an optimal tax policy and issues a full set of contingent claims, the value of debt has the same or less persistence than other variables in the economy and declines in response to higher government expenditure shocks. Examining US data however reveals that debt is substantially more persistent than other variables and increases in response to adverse expenditure shocks. We show that this behaviour is best accounted for by a model of incomplete markets, where governments only issue one-period risk free bonds. We discuss the implications of this for the optimality of debt limits, debt management and assessing the sustainability of fiscal policy.