Optimal Public Debt Management and Liquidity Provision
54 Pages Posted: 16 Feb 2013 Last revised: 15 May 2023
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Optimal Public Debt Management and Liquidity Provision
Optimal Public Debt Management and Liquidity Provision
Date Written: February 2013
Abstract
We study the Ramsey policy problem in an economy in which firms face a collateral constraint. Issuing more public debt alleviates this friction by increasing the aggregate quantity of collateral. In so doing, however, the issuance of more debt also raises interest rates, which in turn increases the tax burden of servicing the entire outstanding debt. We first document how this trade-off upsets the optimality of tax smoothing and, in contrast to the standard paradigm, helps induce a unique and stable steady-state level of debt in the deterministic version of the model. We next study the optimal policy response to fiscal and financial shocks in the stochastic version. We finally show how the results extend to a variant model in which the financial friction afflicts consumers rather than firms.
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