Government Debt Management and Inflation with Real and Nominal Bonds

Lukas Schmid (), Vytautas Valaitis and Alessandro T. Villa ()
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Lukas Schmid: Marshall School of Business, University of Southern California
Alessandro T. Villa: Federal Reserve Bank of Chicago

No 2413, Discussion Papers from Centre for Macroeconomics (CFM)

Abstract: Can governments use Treasury Inflation-Protected Securities (TIPS) to tame inflation? We propose a novel framework of optimal debt management with sticky prices and a government issuing nominal and real state-uncontingent bonds. Nominal debt can be monetized giving ex-ante flexibility, whereas real bonds are cheaper but constitute a commitment ex-post. Under Full Commitment, the government chooses a leveraged and volatile portfolio of nominal liabilities and real assets to use inflation to smooth taxes. With No Commitment, it reduces borrowing costs ex-ante using a stable real debt share strategically to prevent future governments from monetizing debt ex-post. Such policies rationalize the small and persistent real debt share in U.S. data, with higher TIPS shares effectively curbing inflation. Reducing future governments’ temptation to monetize debt renders debt and inflation endogenously sticky.

Keywords: Optimal Fiscal Policy; Monetary Policy; Debt Management; TIPS; Incomplete Markets; Inflation; Limited Commitment; Time-consistency; Markov-perfect Equilibria (search for similar items in EconPapers)
Pages: 72 pages
Date: 2024-03
New Economics Papers: this item is included in nep-ban, nep-cba, nep-dge, nep-fmk and nep-mon
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Related works:
Working Paper: Government Debt Management and Inflation with Real and Nominal Bonds (2023)
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Persistent link: https://EconPapers.repec.org/RePEc:cfm:wpaper:2413

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