Working Paper: CEPR ID: DP9965
Authors: Elisa Faraglia; Albert Marcet; Andrew Scott
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.
Keywords: debt management; fiscal policy; government debt; maturity structure; tax smoothing; yield curve
JEL Codes: E43; E62; H63
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| issuance of long-term bonds (H74) | increased tax volatility (H29) |
| increased tax volatility (H29) | lower future interest rates (E43) |
| lower future interest rates (E43) | reduced funding costs (G32) |
| government indebtedness and issuance of long bonds (H63) | announced intentions to cut future taxes (H32) |
| announced intentions to cut future taxes (H32) | monitoring of commitments to cut taxes over time (H26) |
| longer maturity of bonds (G12) | more complex monitoring of commitments (E61) |
| government's fiscal policy (E62) | subordinate to debt management concerns (H63) |
| increasing taxes initially (H29) | managing debt obligations (H63) |
| promised tax cuts (H29) | introduces dynamics not present in short-term debt models (G19) |
| tax rates (H29) | respond to shocks (E32) |
| patterns of response in tax rates (H32) | differ between models with long and short bonds (G12) |