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Time Consistent Debt

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Author Info

  • Per Krusell
  • Fernando M. Martin
  • Jose-Victor Rios-Rull

Abstract

In this paper we address the time-inconsistency of optimal debt policy—the incentive for a current government to “manipulate interest ratesâ€â€”raised in Lucas and Stokey’s celebrated 1983 paper. The literature that followed suggested various ways to fully overcome the timeconsistency problem or support the commitment outcome despite the lack of commitment. Perhaps surprisingly, however, there is no analysis of what an equilibrium would look like in the basic model with one-period bonds. The present paper provides this analysis. Our main result is striking: the time series of debt in the economy without commitment is extremely similar (though not identical) to that with commitment, and welfare is very similar as well. This result is surprising: under commitment, there is always an incentive for a once-and-for-all tax cut/debt hike, thus suggesting ever-increasing debt under lack of commitment. However, we show that the incentives that naturally arise in the dynamic game between successive governments actually help limit the time-consistency problem: they lead to very limited debt accumulation, and long-run debt levels can even be lower than under commitment. This incentive mechanism is a result of forward-looking and strategic use of debt and of nonconvexities whose fundamental origin is the disagreement between consecutive governments: the time-consistency problem. We thus learn from our analysis that, in stark contrast to other contexts (e.g, the case of capital income taxation), the time-consistency problems associated with interest-rate manipulation are not as severe as may first appear. The incentives generated by the successive interactions of rational governments all but eliminate the problem, without added instruments—such as a rich maturity structure of the government’s debt portfolio—and without institutional reforms

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Bibliographic Info

Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 210.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:210

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Related research

Keywords: Government debt; markov equilibria; time-consistency;

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Citations

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Cited by:
  1. Paul Klein & Per Krusell & José-Víctor Ríos-Rull, 2004. "Time-Consistent Public Expenditures," Levine's Bibliography 122247000000000652, UCLA Department of Economics.
  2. Stefan Niemann & Paul Pichler, 2013. "Collateral, Liquidity and Debt Sustainability," Working Papers 187, Oesterreichische Nationalbank (Austrian Central Bank).
  3. repec:onb:oenbwp:y:2013:i:187:b:1 is not listed on IDEAS
  4. Zheng Song & Kjetil Storesletten & Fabrizio Zilibotti, 2007. "Rotten Parents and Disciplined Children: A Politico-Economic Theory of Public Expenditure and Debt," 2007 Meeting Papers 685, Society for Economic Dynamics.
  5. Fernando M. Martin, 2004. "A Positive Theory of Government Debt," Macroeconomics 0408013, EconWPA, revised 12 Oct 2004.
  6. Davide Debortoli & Ricardo Nunes, 2007. "Loose commitment," International Finance Discussion Papers 916, Board of Governors of the Federal Reserve System (U.S.).
  7. Leena Rudanko & Per Krusell, 2012. "Unions in a Frictional Labor Market," Boston University - Department of Economics - Working Papers Series WP2012-014, Boston University - Department of Economics.
  8. Salvador Ortigueira & Joana Pereira, 2007. "Markov-Perfect Optimal Fiscal Policy: The Case of Unbalanced Budgets," Economics Working Papers ECO2007/41, European University Institute.
  9. Filippo Occhino, 2006. "Optimal Fiscal Policy over the Business Cycle," 2006 Meeting Papers 608, Society for Economic Dynamics.
  10. Fernando Martin, 2009. "On the Joint Determination of Fiscal and Monetary Policy," Discussion Papers dp09-01, Department of Economics, Simon Fraser University.

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