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Fiscal Hedging and the Yield Curve

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  • Hanno Lustig
  • Christopher Sleet
  • Sevin Yeltekin

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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 11687.

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Date of creation: Oct 2005
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Publication status: published as Lustig, Hanno, Chris Sleet, and Sevin Yeltekin. "Fiscal Hedging with Nominal Assets." Journal of Monetary Economics 55, 4(2008).
Handle: RePEc:nbr:nberwo:11687

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  1. John Y. Campbell, 1995. "Some Lessons from the Yield Curve," NBER Working Papers 5031, National Bureau of Economic Research, Inc.
  2. Isabel Horta Correia & Juan Pablo Nicolini & Pedro Teles, 2003. "Optimal Fiscal and Monetary Policy: Equivalence Results," Working Papers w200303, Banco de Portugal, Economics and Research Department.
  3. Kamihigashi, Takashi, 2003. "Necessity of transversality conditions for stochastic problems," Journal of Economic Theory, Elsevier, vol. 109(1), pages 140-149, March.
  4. Robert E. Lucas Jr. & Nancy L. Stokey, 1982. "Optimal Fiscal and Monetary Policy in an Economy Without Capital," Discussion Papers 532, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  5. Fernando Lefort & Klaus Schmidt-Hebbel, 2002. "Indexation, Inflation and Monetary Policy: An Overview," Central Banking, Analysis, and Economic Policies Book Series, in: Fernando Lefort & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Serie (ed.), Indexation, Inflation and MOnetary Policy, edition 1, volume 2, chapter 1, pages 001-018 Central Bank of Chile.
  6. Robert J. Barro, 1995. "Optimal Debt Management," NBER Working Papers 5327, National Bureau of Economic Research, Inc.
  7. George-Marios Angeletos, 2002. "Fiscal Policy With Noncontingent Debt And The Optimal Maturity Structure," The Quarterly Journal of Economics, MIT Press, vol. 117(3), pages 1105-1131, August.
  8. Albert Marcet & Thomas J. Sargent & Juha Seppala, 1996. "Optimal taxation without state-contingent debt," Economics Working Papers 170, Department of Economics and Business, Universitat Pompeu Fabra, revised Oct 2001.
  9. Alessandro Missale & Olivier Jean Blanchard, 1991. "The Debt Burden and Debt Maturity," NBER Working Papers 3944, National Bureau of Economic Research, Inc.
  10. Qiang Dai & Thomas Philippon, 2005. "Fiscal Policy and the Term Structure of Interest Rates," NBER Working Papers 11574, National Bureau of Economic Research, Inc.
  11. Sevin Yeltekin & Hanno Lustig & Chris Sleet, 2004. "Does the US government hedge against government expenditure risk?," 2004 Meeting Papers 48, Society for Economic Dynamics.
  12. Juan Pablo Nicolini & Francisco Buera, 2002. "Optimal Maturity of Governement Debt without state contingent bonds," Department of Economics Working Papers 016, Universidad Torcuato Di Tella.
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Cited by:
  1. Yili Chien & Harold Cole & Hanno Lustig, 2011. "A Multiplier Approach to Understanding the Macro Implications of Household Finance," Review of Economic Studies, Oxford University Press, vol. 78(1), pages 199-234.
  2. Cristina Arellano & Ananth Ramanarayanan, 2008. "Default and the maturity structure in sovereign bonds," Staff Report 410, Federal Reserve Bank of Minneapolis.

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