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The social value of risk-free government debt

Listed author(s):
  • Stacey Schreft

    ()

  • Bruce Smith

This paper considers whether eliminating the stock of government debt outstanding would reduce welfare. It models an economy with three assets—currency, government bonds, and storage, a transactions role for money, and a demand for liquidity and thus a role for banks. The Friedman rule is not optimal in this economy, so there is potentially a role for interest-bearing, risk-free government bonds. Because the government must raise enough revenue to meet its interest obligations on any bonds outstanding, the social value of government debt hinges on whether the benefits from greater portfolio diversification outweigh the costs associated with the necessary revenue-raising efforts. The paper shows that a positive stock of government debt is optimal only if interest payments on the debt are financed via money creation, agents are not too risk averse, there is a primary government budget deficit, and the economy is operating on the bad side of the Laffer curve. But under these conditions, welfare would be even higher if monetary policy were conducted to put the economy on the good side of the Laffer curve and there were no government bonds outstanding. Thus, there is little support for keeping a stock of interest-bearing, risk-free government debt outstanding.

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File URL: http://hdl.handle.net/10.1007/s10436-007-0073-3
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Article provided by Springer in its journal Annals of Finance.

Volume (Year): 4 (2008)
Issue (Month): 2 (March)
Pages: 131-155

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Handle: RePEc:kap:annfin:v:4:y:2008:i:2:p:131-155
DOI: 10.1007/s10436-007-0073-3
Contact details of provider: Web page: http://www.springer.com

Order Information: Web: http://www.springer.com/finance/journal/10436/PS2

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  1. Beatrix Paal & Bruce D. Smith, 2013. "The sub-optimality of the Friedman rule and the optimum quantity of money," Annals of Economics and Finance, Society for AEF, vol. 14(2), pages 911-948, November.
  2. de V. Cavalcanti, Tiago V. & Villamil, Anne P., 2003. "Optimal Inflation Tax And Structural Reform," Macroeconomic Dynamics, Cambridge University Press, vol. 7(03), pages 333-362, June.
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  4. Chari, V.V. & Kehoe, Patrick J., 1999. "Optimal fiscal and monetary policy," Handbook of Macroeconomics,in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 26, pages 1671-1745 Elsevier.
  5. Aiyagari, S. Rao & Gertler, Mark, 1991. "Asset returns with transactions costs and uninsured individual risk," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 311-331, June.
  6. Andrew B. Abel & N. Gregory Mankiw & Lawrence H. Summers & Richard J. Zeckhauser, 1989. "Assessing Dynamic Efficiency: Theory and Evidence," Review of Economic Studies, Oxford University Press, vol. 56(1), pages 1-19.
  7. Aiyagari, S. Rao & McGrattan, Ellen R., 1998. "The optimum quantity of debt," Journal of Monetary Economics, Elsevier, vol. 42(3), pages 447-469, October.
  8. Smith, Bruce D. & Villamil, Anne P., 1998. "Government borrowing using bonds with randomly determined returns: Welfare improving randomization in the context of deficit finance," Journal of Monetary Economics, Elsevier, vol. 41(2), pages 351-370, April.
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  11. Townsend, Robert M, 1987. "Economic Organization with Limited Communication," American Economic Review, American Economic Association, vol. 77(5), pages 954-971, December.
  12. Schreft, Stacey L. & Smith, Bruce D., 2000. "The evolution of cash transactions: Some implications for monetary policy," Journal of Monetary Economics, Elsevier, vol. 46(1), pages 97-120, August.
  13. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  14. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Win, pages 14-23.
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  16. Lucas, Robert Jr. & Stokey, Nancy L., 1983. "Optimal fiscal and monetary policy in an economy without capital," Journal of Monetary Economics, Elsevier, vol. 12(1), pages 55-93.
  17. Schreft, Stacey L & Smith, Bruce D, 2002. "The Conduct of Monetary Policy with a Shrinking Stock of Government Debt," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(3), pages 848-882, August.
  18. Bruce Smith & J. Bhattacharya & Mark Guzman, 1998. "Some Even More Unpleasant Monetarist Arithmetic," Canadian Journal of Economics, Canadian Economics Association, vol. 31(3), pages 596-623, August.
  19. Aiyagari, S. Rao & Gertler, Mark, 1991. "Asset returns with transactions costs and uninsured individual risk," Journal of Monetary Economics, Elsevier, vol. 27(3), pages 311-331, June.
  20. Villamil, Anne P., 1988. "Price discriminating monetary policy : A nonuniform pricing approach," Journal of Public Economics, Elsevier, vol. 35(3), pages 385-392, April.
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  23. Bruce D. Smith, 2003. "Taking intermediation seriously," Proceedings, Federal Reserve Bank of Cleveland, pages 1319-1377.
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