Government Debt Dynamics Under Discretion

This paper studies the dynamics of state-contingent government debt in the case that the fiscal authority cannot commit to a future policy. As is well known, optimal policy under commitment calls for letting debt follow a stationary process, with values that depend on the initial conditions. In contrast, when the fiscal authority lacks the ability to commit, it manipulates its policy tools, i.e. the tax rate and government spending, in order to reduce the intertemporal price of current consumption goods, i.e. the real interest rate, and the intertemporal value of its current outstanding liabilities. If the economy converges, in any steady state the government has either no incentive or no ability to reduce the real interest rate any longer.