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Debt and Deficit Fluctuations and the Structure of Bond Markets

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  • Albert Marcet
  • Andrew Scott

Abstract

This paper tests for the market environment within which US fiscal policy operates, that is we test for the incompleteness of the US government bond market. We document the stochastic properties of US debt and deficits and then consider the ability of competing optimal tax models to account for this behaviour. We show that when a government pursues an optimal tax policy and issues a full set of contingent claims, the value of debt has the same or less persistence than other variables in the economy and declines in response to higher deficit shocks. By contrast, if governments only issue one-period risk free bonds (incomplete markets), debt shows more persistence than other variables and it increases in response to expenditure shocks. Maintaining the hypothesis of Ramsey behavior, US data conflicts strongly with the predictions of complete markets but is much more consistent with incomplete markets. We discuss the implications of this finding for the optimality of debt limits, debt management and assessing the sustainability of fiscal policy.

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Bibliographic Info

Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 171.

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Date of creation: Jun 2003
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Handle: RePEc:bge:wpaper:171

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Keywords: Complete vs incomplete markets; Debt Management; Govertment Debt; Optimal fiscal policy; Tax smoothing;

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