Becker Friedman Institute

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Dealing with Maturity: Optimal Fiscal Policy with Long Bonds

We study Ramsey optimal fiscal policy under incomplete markets in the case where the government issues only long bonds of maturity N > 1. We find that many features of optimal policy are sensitive to the introduction of long bonds, in particular tax variability and the long run behavior of debt. When government is indebted it is optimal to respond to an adverse shock by promising to reduce taxes in the distant future as this achieves a cut in the cost of debt. Hence, debt management concerns about the cost of debt override typical fiscal policy concerns such as tax smoothing. In the case when the government leaves bonds in the market until maturity another source of tax volatility is that optimal policy imparts N-period cycles in taxes. We formulate the equilibrium recursively applying the Lagrangean approach for recursive contracts. Even with this approach the dimension of the state vector is very large. We propose a flexible numerical method to address this issue, the "condensed PEA", which substantially reduces the required state space. This technique has a wide range of applications. To explore issues of policy coordination and commitment we propose an alternative model where monetary and fiscal authorities are independent.

Albert Marcet, Institut d'Anàlisi Economica CSIC
Elisa Faraglia, University of Cambridge
Andrew Scott, London Business School
Publication Date: 
October, 2011
BFI Initiative: 
Publication Status: