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Government Debt Management and Inflation with Real and Nominal Bonds

Author

Listed:
  • Lukas Schmid

    (Marshall School of Business, University of Southern California
    Centre for Economic Policy Research (CEPR))

  • Vytautas Valaitis

    (University of Surrey)

  • Alessandro T. Villa

    (Federal Reserve Bank of Chicago)

Abstract

Can governments use Treasury Inflation-Protected Securities (TIPS) to tame inflation? We propose a novel framework of optimal debt management with sticky prices and a government issuing nominal and real state-uncontingent bonds. Nominal debt can be monetized giving ex-ante flexibility, whereas real bonds are cheaper but constitute a commitment ex-post. Under Full Commitment, the government chooses a leveraged and volatile portfolio of nominal liabilities and real assets to use inflation to smooth taxes. With No Commitment, it reduces borrowing costs ex-ante using a stable real debt share strategically to prevent future governments from monetizing debt ex-post. Such policies rationalize the small and persistent real debt share in U.S. data, with higher TIPS shares effectively curbing inflation. Reducing future governments’ temptation to monetize debt renders debt and inflation endogenously sticky.

Suggested Citation

  • Lukas Schmid & Vytautas Valaitis & Alessandro T. Villa, 2024. "Government Debt Management and Inflation with Real and Nominal Bonds," Discussion Papers 2413, Centre for Macroeconomics (CFM).
    • Handle: RePEc:cfm:wpaper:2413
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    File URL: https://www.lse.ac.uk/CFM/assets/pdf/CFM-Discussion-Papers-2024/CFMDP2024-13-Paper.pdf
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    More about this item

    Keywords

    Optimal Fiscal Policy; Monetary Policy; Debt Management; TIPS; Incomplete Markets; Inflation; Limited Commitment; Time-consistency; Markov-perfect Equilibria;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • 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; Modern Monetary Theory
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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