Working Paper: CEPR ID: DP18197
Authors: Lukas Schmid; Vytautas Valaitis; Alessandro Villa
Abstract: Can governments use TIPS to tame inflation? We propose a novel framework of optimal debt management with sticky prices and a government that issues nominal and real state-uncontingent bonds. Nominal debt can be monetized giving ex-ante flexibility, whereas real bonds are cheaper but constitute a commitment ex-post. Under Full Commitment, the government chooses a leveraged portfolio of nominal liabilities and real assets to use inflation to smooth taxes. With No Commitment, it reduces borrowing costs ex-ante using real debt strategically to prevent future governments from monetizing debt ex-post. Such policies match U.S. data, with higher TIPS shares effectively curbing inflation.
Keywords: Optimal fiscal policy; Optimal debt management; TIPS; Incomplete markets; Inflation; Monetary policy; Limited commitment; Time-consistency; Markov-perfect equilibria
JEL Codes: E44; E52; E62; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| government's choice of bond composition (H63) | inflation dynamics (E31) |
| increasing the share of real bonds (G12) | curb inflation (E31) |
| real bonds (G12) | reduce future governments' incentives to inflate away nominal debt (H63) |
| nominal debt can be inflated away (H63) | ex-ante flexibility (D84) |
| real bonds are cheaper (E43) | represent a commitment ex-post (D86) |
| higher share of TIPS (G12) | mitigate inflationary pressures (E31) |