The Social Value of Risk-Free Government Debt

FRB of Kansas City Working Paper No. 03-02

33 Pages Posted: 11 Jun 2003

See all articles by Stacey Schreft

Stacey Schreft

Government of the United States of America - Office of Financial Research; Board of Governors of the Federal Reserve System

Bruce D. Smith

University of Texas at Austin (Deceased)

Date Written: February 2003

Abstract

This paper considers whether eliminating the stock of government debt outstanding would reduce welfare. It models an economy with three assets - currency, government bonds, and storage, a transactions role for money, and a demand for liquidity and thus a role for banks. The Friedman rule is not optimal in this economy, so there is potentially a role for interest-bearing, risk-free government bonds. Because the government must raise enough revenue to meet its interest obligations on any bonds outstanding, the social value of government debt hinges on whether the benefits from greater portfolio diversification outweigh the costs associated with the necessary revenue-raising efforts. The paper shows that a positive stock of government debt is optimal only if interest payments on the debt are financed via money creation, agents are not too risk averse, there is a primary government budget deficit, and the economy is operating on the bad side of the Laffer curve. But under these conditions, welfare would be even higher if monetary policy were conducted to put the economy on the good side of the Laffer curve and there were no government bonds outstanding. Thus, there is little support for keeping a stock of interest-bearing, risk-free government debt outstanding.

Keywords: Government Debt, Fiscal Policy, Monetary Policy, Portfolio Allocation

JEL Classification: E0, E4, E5, E6, H6, G1

Suggested Citation

Schreft, Stacey L. and Smith, Bruce D., The Social Value of Risk-Free Government Debt (February 2003). FRB of Kansas City Working Paper No. 03-02, Available at SSRN: https://ssrn.com/abstract=394622 or http://dx.doi.org/10.2139/ssrn.394622

Stacey L. Schreft (Contact Author)

Government of the United States of America - Office of Financial Research ( email )

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Washington DC, DC 20005
United States

Board of Governors of the Federal Reserve System ( email )

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Washington, DC 20551
United States

Bruce D. Smith

University of Texas at Austin (Deceased)

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