Debt-Maturity Management with Liquidity Costs

Abstract

We characterize the optimal debt-maturity management problem of a government in a small open economy. The government issues a continuum of fi nite-maturity bonds in the presence of liquidity frictions. We fi nd that the solution can be decentralized: the optimal issuance of a bond of a given maturity is proportional to the difference between its market price and its domestic valuation, the latter defi ned as the price computed using the government's discount factor. We show how the steady-state debt distribution decreases with maturity. These results hold when extending the model to incorporate aggregate risk or strategic default.

A Preferred‐Habitat Model of the Term Structure of Interest Rates

“…One direction is to derive optimal debt issuance by governments or corporations when investors have preferences for specific maturities. Work along these lines includes Greenwood, Hanson, and Stein (2010), Guibaud, Nosbusch, and Vayanos (2013), and Bigio, Nuno, and Passadore (2019). Another direction is to broaden the asset‐pricing implications by allowing arbitrageurs to trade additional assets.…”

Confederation debt management since 1970

“…Buera and Nicolini (2004) and Angeletos (2002) represent benchmark specifications in an incomplete market setting with debt of different maturities. These models fail to observe typical treasury behavior that more recent literature tries to replicate by means of restricting the government from going short in any maturity (Lustig, Sleet, and Yeltekin (2008), restricting the government's ability to commit (Debortoli et al, 2017), tying model closer to observed asset prices (Bhandari et al, 2017), considering the price impact of each issuance of an impatient government (Bigio, Nuño, & Passadore, 2018) and restricting the government ability to rebalance its portfolio (Faraglia et al, 2018).…”

Optimal Fiscal Policy without Commitment: Revisiting Lucas-Stokey

“…Bocola and Dovis (2016) additionally consider the presence of liquidity risk. Bigio et al (2017) consider debt maturity in the presence of transactions costs. Arellano et al (2013) consider lack of commitment when surprise inflation is possible.…”