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A Positive Theory of Government Debt

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Author Info
Fernando M. Martin (University of Pennsylvania)

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Abstract

All developed countries have government debt, usually a sizeable proportion of output. This paper proposes that governments that cannot commit to future policy choices face a trade-off that explains the level of debt. On the one hand, the government would like to increase debt and delay taxation, so as to reduce current distortions. On the other hand, inflating current prices lowers the real value of nominal debt and so there is a motive to reduce it now. This trade-off generates a level of long-run debt that is interior and independent of initial debt, a feature missing in previous theories. The sign and size of long-run debt will depend on how the incentives to increase and decrease debt play out against each other. The critical determinant is how easy or difficult it is for households to substitute away from goods being taxed by inflation. Under reasonable assumptions, the model is successful in replicating certain U.S. facts, most importantly its debt-to-output ratio. Permanent changes in fundamentals —other than the degree of substitutability of the good being taxed by inflation— have small effects on long-run debt. This is consistent with the empirical observation that macroeconomic variables cannot alone explain cross-country differences in public debt levels. The model is extended to include stochastic government expenditure. In line with the tax-smoothing argument, the model predicts that governments increase debt when expenditure temporarily rises. However, labor taxes fluctuate significantly.

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Paper provided by EconWPA in its series Macroeconomics with number 0408013.

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Length: 33 pages
Date of creation: 29 Aug 2004
Date of revision: 12 Oct 2004
Handle: RePEc:wpa:wuwpma:0408013

Note: Type of Document - pdf; pages: 33
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Web page: http://129.3.20.41

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Related research
Keywords: Government debt; time-consistency; Markov-perfect equilibrium.;

Other versions of this item:

Find related papers by JEL classification:
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
H63 - Public Economics - - National Budget, Deficit, and Debt - - - Debt; Debt Management

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References listed on IDEAS
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    Other versions:
  2. Klein, Paul & Krusell, Per & Ríos-Rull, José-Víctor, 2004. "Time Consistent Public Expenditures," CEPR Discussion Papers 4582, C.E.P.R. Discussion Papers. [Downloadable!] (restricted)
    Other versions:
  3. Svensson, Lars E O, 1985. "Money and Asset Prices in a Cash-in-Advance Economy," Journal of Political Economy, University of Chicago Press, vol. 93(5), pages 919-44, October. [Downloadable!] (restricted)
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  5. Alberto Alesina & Roberto Perotti, 1996. "Budget Deficits and Budget Institutions," IMF Working Papers 96/52, International Monetary Fund.
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  6. Barro, Robert J, 1979. "On the Determination of the Public Debt," Journal of Political Economy, University of Chicago Press, vol. 87(5), pages 940-71, October. [Downloadable!] (restricted)
  7. Douglas W. Elmendorf & N. Gregory Mankiw, 1998. "Government debt," Finance and Economics Discussion Series 1998-09, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
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  8. S. Rao Aiyagari & R. Anton Braun & Zvi Eckstein, 1998. "Transaction Services, Inflation, and Welfare," Journal of Political Economy, University of Chicago Press, vol. 106(6), pages 1274-1301, December. [Downloadable!] (restricted)
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  9. Robert E. Lucas, Jr., 2000. "Inflation and Welfare," Econometrica, Econometric Society, vol. 68(2), pages 247-274, March.
  10. Javier Díaz-Giménez & Giorgia Giovannetti & Ramon Marimon & Pedro Teles, 2004. "Nominal debt as a burden on monetary policy," Working Paper Series WP-04-10, Federal Reserve Bank of Chicago. [Downloadable!]
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  11. Bassetto, Marco & Kocherlakota, Narayana, 2004. "On the irrelevance of government debt when taxes are distortionary," Journal of Monetary Economics, Elsevier, vol. 51(2), pages 299-304, March. [Downloadable!] (restricted)
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  12. Cooley, Thomas F & Hansen, Gary D, 1991. "The Welfare Costs of Moderate Inflations," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 483-503, August. [Downloadable!] (restricted)
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  13. Erosa, Andres & Ventura, Gustavo, 2002. "On inflation as a regressive consumption tax," Journal of Monetary Economics, Elsevier, vol. 49(4), pages 761-795, May. [Downloadable!] (restricted)
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  14. Per Krusell & Fernando M. Martin & Jose-Voctor Rios-Rull, 2006. "Time Consistent Debt," 2006 Meeting Papers 210, Society for Economic Dynamics.
  15. Barro, Robert J, 1974. "Are Government Bonds Net Wealth?," Journal of Political Economy, University of Chicago Press, vol. 82(6), pages 1095-1117, Nov.-Dec.. [Downloadable!] (restricted)
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  18. Henning Bohn, 1998. "The Behavior Of U.S. Public Debt And Deficits," The Quarterly Journal of Economics, MIT Press, vol. 113(3), pages 949-963, August. [Downloadable!] (restricted)
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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Davide Debortoli & Ricardo Nunes, 2008. "Political disagreement, lack of commitment and the level of debt," International Finance Discussion Papers 938, Board of Governors of the Federal Reserve System (U.S.). [Downloadable!]
  2. Javier Diaz-Gimenez & Giorgia Giovannetti & Ramon Marimon & Pedro Teles, 2008. "Nominal Debt as a Burden on Monetary Policy," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(3), pages 493-514, July. [Downloadable!] (restricted)
    Other versions:
  3. Salvador Ortigueira & Joana Pereira, 2007. "Markov-Perfect Optimal Fiscal Policy: The Case of Unbalanced Budgets," Economics Working Papers ECO2007/41, European University Institute. [Downloadable!]
  4. Philippe Michel & Leopold von Thadden & Jean-Piere Vidal, 2005. "Debt stabilizing fiscal rules," Computing in Economics and Finance 2005 349, Society for Computational Economics. [Downloadable!]
    Other versions:
  5. Michael Kumhof & Irina Yakadina, 2007. "Politically Optimal Fiscal Policy," IMF Working Papers 07/68, International Monetary Fund. [Downloadable!]
  6. Stefan Niemann & Paul Pichler & Gerhard Sorger, 2008. "Optimal Fiscal and Monetary Policy Without Commitment," Economics Discussion Papers 654, University of Essex, Department of Economics. [Downloadable!]
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