Fiscal Hedging and the Yield Curve

Hanno Lustig, Christopher Sleet and Sevin Yeltekin ()

No 11687, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E4 E6 G1 (search for similar items in EconPapers)
Date: 2005-10
New Economics Papers: this item is included in nep-fin, nep-mac, nep-mon and nep-pbe
Note: EFG ME AP PE
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Citations: View citations in EconPapers (4)

Published as Lustig, Hanno, Chris Sleet, and Sevin Yeltekin. "Fiscal Hedging with Nominal Assets." Journal of Monetary Economics 55, 4(2008).

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