1. Assuming the existence of long bonds introduces an additional intertemporal mechanism that makes taxes more volatile in order to achieve lower debt management costs. In other words, fiscal policy is secondary to debt management. Modelling optimal policy with long term bonds is computationally demanding because of the promises made to cut future taxes. The longer the maturity of bonds the more promises need to be monitored and the larger the state space. We consider three means of overcoming this problem - a computational method using the ?condensed PEA?, an approximation whereby long bonds are modelled as a sequence of geometrically declining coupons and a model of independent powers where the fiscal authority and interest rate setting authority are separate. We compare the accuracy and properties of solutions across these three approaches and examine how the properties of optimal fiscal policy differ in the case of long bonds compared to one period debt."> 1. Assuming the existence of long bonds introduces an additional intertemporal mechanism that makes taxes more volatile in order to achieve lower debt management costs. In other words, fiscal policy is secondary to debt management. Modelling optimal policy with long term bonds is computationally demanding because of the promises made to cut future taxes. The longer the maturity of bonds the more promises need to be monitored and the larger the state space. We consider three means of overcoming this problem - a computational method using the ?condensed PEA?, an approximation whereby long bonds are modelled as a sequence of geometrically declining coupons and a model of independent powers where the fiscal authority and interest rate setting authority are separate. We compare the accuracy and properties of solutions across these three approaches and examine how the properties of optimal fiscal policy differ in the case of long bonds compared to one period debt."> 1. Assuming ">
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Modelling Long Bonds - The Case of Optimal Fiscal Policy

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  • Marcet, Albert
  • Scott, Andrew
  • Faraglia, Elisa
Abstract
We show how to model portfolio models in the presence of long bonds. Specifically we study optimal fiscal policy under incomplete markets where the government issues bonds of maturity N > 1. Assuming the existence of long bonds introduces an additional intertemporal mechanism that makes taxes more volatile in order to achieve lower debt management costs. In other words, fiscal policy is secondary to debt management. Modelling optimal policy with long term bonds is computationally demanding because of the promises made to cut future taxes. The longer the maturity of bonds the more promises need to be monitored and the larger the state space. We consider three means of overcoming this problem - a computational method using the ?condensed PEA?, an approximation whereby long bonds are modelled as a sequence of geometrically declining coupons and a model of independent powers where the fiscal authority and interest rate setting authority are separate. We compare the accuracy and properties of solutions across these three approaches and examine how the properties of optimal fiscal policy differ in the case of long bonds compared to one period debt.

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  • Marcet, Albert & Scott, Andrew & Faraglia, Elisa, 2014. "Modelling Long Bonds - The Case of Optimal Fiscal Policy," CEPR Discussion Papers 9965, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:9965
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    References listed on IDEAS

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    1. Cristina Arellano & Ananth Ramanarayanan, 2012. "Default and the Maturity Structure in Sovereign Bonds," Journal of Political Economy, University of Chicago Press, vol. 120(2), pages 187-232.
    2. Robert Barro, 2003. "Optimal Management of Indexed and Nominal Debt," Annals of Economics and Finance, Society for AEF, vol. 4(1), pages 1-15, May.
    3. Fernando A. Broner & Guido Lorenzoni & Sergio L. Schmukler, 2013. "Why Do Emerging Economies Borrow Short Term?," Journal of the European Economic Association, European Economic Association, vol. 11, pages 67-100, January.
    4. den Haan, Wouter J & Marcet, Albert, 1990. "Solving the Stochastic Growth Model by Parameterizing Expectations," Journal of Business & Economic Statistics, American Statistical Association, vol. 8(1), pages 31-34, January.
    5. Faraglia, Elisa & Marcet, Albert & Scott, Andrew, 2010. "In search of a theory of debt management," Journal of Monetary Economics, Elsevier, vol. 57(7), pages 821-836, October.
    6. Elisa Faraglia & Albert Marcet & Andrew Scott, 2008. "Fiscal Insurance and Debt Management in OECD Economies," Economic Journal, Royal Economic Society, vol. 118(527), pages 363-386, March.
    7. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-971, October.
    8. Buera, Francisco & Nicolini, Juan Pablo, 2004. "Optimal maturity of government debt without state contingent bonds," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 531-554, April.
    9. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
    10. Woodford, Michael, 2001. "Fiscal Requirements for Price Stability," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 33(3), pages 669-728, August.
    11. George-Marios Angeletos, 2002. "Fiscal Policy with Noncontingent Debt and the Optimal Maturity Structure," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 117(3), pages 1105-1131.
    12. Yves Nosbusch, 2008. "Interest Costs and the Optimal Maturity Structure Of Government Debt," Economic Journal, Royal Economic Society, vol. 118(527), pages 477-498, March.
    13. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
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    Cited by:

    1. Leeper, Eric M. & Leith, Campbell & Liu, Ding, 2021. "Optimal Time-Consistent Monetary, Fiscal and Debt Maturity Policy," Journal of Monetary Economics, Elsevier, vol. 117(C), pages 600-617.
    2. Tiago Berriel & Rodrigo Abreu, 2015. "Long Term Debt and Credit Crisis in a Liquidity Constrained Economy," Textos para discussão 644, Department of Economics PUC-Rio (Brazil).

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    More about this item

    Keywords

    Debt management; Fiscal policy; Government debt; Maturity structure; Tax smoothing; Yield curve;
    All these keywords.

    JEL classification:

    • E43 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Interest Rates: Determination, Term Structure, and Effects
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management; Sovereign Debt

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