Working Paper: NBER ID: w11687
Authors: Hanno Lustig; Chris Sleet; Evin Yeltekin
Abstract: We identify a novel, fiscal hedging motive that helps to explain why governments issue more expensive, long-term debt. We analyze optimal fiscal policy in an economy with distortionary labor income taxes, nominal rigidities and nominal debt of various maturities. The government in our model can smooth labor tax rates by changing the real return it pays on its outstanding liabilities. These changes require state contingent inflation or adjustments in the nominal term structure. In the presence of nominal pricing rigidities and a cash in advance constraint, these changes are themselves distortionary. We show that long term nominal debt can help a government hedge fiscal shocks by spreading out and delaying the distortions associated with increases in nominal interest rates over the maturity of the outstanding long-term debt. After a positive spending shock, the government raises the yield curve and steepens it.
Keywords: No keywords provided
JEL Codes: E4; E6; G1
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| long-term nominal debt (H63) | hedge fiscal shocks (E62) |
| fiscal shocks (E62) | distortions associated with increases in nominal interest rates (E43) |
| debt maturity (H63) | fiscal policy outcomes (E62) |
| government spending shocks (E62) | nominal yields (G12) |
| government spending shocks (E62) | yield curve (E43) |
| longest-term debt (H63) | effectiveness of government fiscal strategies (E62) |