Fiscal Policy and Debt Management with Incomplete Markets*

Abstract

A Ramsey planner chooses a distorting tax on labor and manages a portfolio of securities in an economy with incomplete markets. We develop a method that uses second order approximations of Ramsey policies to obtain formulas for conditional and unconditional moments of government debt and taxes that include means and variances of the invariant distribution as well as speeds of mean reversion. The asymptotic mean of the planner's portfolio minimizes a measure of fiscal risk. We obtain analytic expressions that approximate moments of the invariant distribution and apply them to data on a primary government deficit, aggregate consumption, and returns on traded securities. For U.S. data, we find that the optimal target debt level is negative but close to zero, the invariant distribution of debt is very dispersed, and mean reversion is slow.

The welfare and distributional effects of fiscal volatility: A quantitative evaluation

“…Finally, our work contributes to the growing body of literature on macroeconomic policy in heterogeneous-agent environments (Auclert, 2017, Bachmann and Bai, 2013a, Bhandari et al, 2016, 2017a,b, Böhm, 2015, Brinca et al, 2016, Dyrda and Pedroni, 2017, Ferriere and Navarro, 2017, Gornemann et al, 2016, Gomes et al, 2013, Hagedorn et al, 2017, Heathcote, 2005, Hedlund et al, 2016, Kaplan and Violante, 2014Kaplan et al, 2016, Li, 2013, McKay and Reis, 2016, and Röhrs and Winter, 2017. There is also a budding empirical literature on the distributional consequences of policy actions: see Coibion et al (2017) for the case of monetary policy and Giorgi and Gambetti (2012) for the case of fiscal policy.…”

Shotgun Wedding

“…Bhandari et al (2018) analyze economies in which distortionary taxes are desirable for social-insurance purposes; since they allow for lump-sum taxes, a representative-agent version of their economy does not feature a need for the government to hedge fiscal risk. 42 Bhandari et al (2016) do not characterize the solution for this case. Since they consider cases in which the real payoff of debt is exogenous, they simply assume it to be such that the optimal hedging value is interior.…”

“…, then the quantity of government debt that achieves the best hedge is larger (a) the more correlated are inflation and the present value of In our reference model, setting nominal liabilities at the optimal hedging solution (26) is not urgent because taxes are lump sum and can be adjusted at no cost. However, in a model with only distorting labor taxes, Bhandari et al (2016) show that an optimal fiscal policy eventually drives government debt to the value (26). Their result reflects the balancing of two forces.…”

“…With long-term debt, ongoing inflation depreciates the 39 We can interpret the exogenous component τ t as the revenues associated with a constant tax rate. 40 Bhandari et al (2016) study a real economy in which the state-contingent payoff of debt one period ahead is exogenously given. This corresponds to our assumption of exogenous inflation since we have assumed that debt is nominally risk free.…”

Optimal Fiscal Policy without Commitment: Beyond Lucas-Stokey

“…Angeletos (2002),Bhandari et al (2017),Buera and Nicolini (2004),Faraglia et al (2010),Guibaud et al (2013), andLustig et al (2008) also consider optimal government debt maturity in the presence of shocks, but they assume full commitment.…”