Debt Management and Optimal Fiscal Policy with Long Bonds

36 Pages Posted: 20 Jun 2012

See all articles by Elisa Faraglia

Elisa Faraglia

London Business School

Albert Marcet

Universitat Autònoma de Barcelona - Institut d'Anàlisi Economica CSIC

Scott Andrews

affiliation not provided to SSRN

Date Written: May 2012

Abstract

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?

Keywords: Computational methods, debt management, fiscal policy, government debt, maturity structure, tax-smoothing, yield curve

JEL Classification: C63, E43, E62, H63

Suggested Citation

Faraglia, Elisa and Marcet, Albert and Andrews, Scott, Debt Management and Optimal Fiscal Policy with Long Bonds (May 2012). BIS Paper No. 65k, Available at SSRN: https://ssrn.com/abstract=2081853

Elisa Faraglia (Contact Author)

London Business School ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

Albert Marcet

Universitat Autònoma de Barcelona - Institut d'Anàlisi Economica CSIC ( email )

Edifici B
Bellaterra, 08193
Spain

Scott Andrews

affiliation not provided to SSRN ( email )

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