Fiscal Hedging and the Yield Curve

59 Pages Posted: 15 Dec 2005 Last revised: 27 Jul 2009

See all articles by Hanno N. Lustig

Hanno N. Lustig

Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Christopher M. Sleet

Carnegie Mellon University - David A. Tepper School of Business

Sevin Yeltekin

Carnegie Mellon University - David A. Tepper School of Business

Date Written: October 2005

Abstract

We identify a novel, fiscal hedging motive that helps to explain why governments issue more expensive, long-term debt. We analyze optimal fiscal policy in an economy with distortionary labor income taxes, nominal rigidities and nominal debt of various maturities. The government in our model can smooth labor tax rates by changing the real return it pays on its outstanding liabilities. These changes require state contingent inflation or adjustments in the nominal term structure. In the presence of nominal pricing rigidities and a cash in advance constraint, these changes are themselves distortionary. We show that long term nominal debt can help a government hedge fiscal shocks by spreading out and delaying the distortions associated with increases in nominal interest rates over the maturity of the outstanding long-term debt. After a positive spending shock, the government raises the yield curve and steepens it.

Suggested Citation

Lustig, Hanno N. and Sleet, Christopher M. and Yeltekin, Sevin, Fiscal Hedging and the Yield Curve (October 2005). NBER Working Paper No. w11687. Available at SSRN: https://ssrn.com/abstract=823190

Hanno N. Lustig (Contact Author)

Stanford Graduate School of Business ( email )

Stanford GSB
655 Knight Way
Stanford, CA California 94305-6072
United States
3108716532 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
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Christopher M. Sleet

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

HOME PAGE: http://business.tepper.cmu.edu/display_faculty.aspx?id=244

Sevin Yeltekin

Carnegie Mellon University - David A. Tepper School of Business ( email )

5000 Forbes Avenue
Pittsburgh, PA 15213-3890
United States

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