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Debt and Deficit Fluctuations and the Structure of Bond Markets

  • Marcet, Albert
  • Scott, Andrew

The aim of this Paper is to test for the extent of incompleteness in the market for US Government debt. We show that when a government pursues an optimal tax policy and issues a full set of contingent claims, the value of debt has the same or less persistence than other variables in the economy and declines in response to higher government expenditure shocks. Examining US data, however, reveals that debt is substantially more persistent than other variables and increases in response to adverse expenditure shocks. We show that this behaviour is best accounted for by a model of incomplete markets, where governments only issue one-period risk-free bonds. We discuss the implications of this for the optimality of debt limits, debt management and assessing the sustainability of fiscal policy.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3029.

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Date of creation: Oct 2001
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Handle: RePEc:cpr:ceprdp:3029
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  1. Emmanuel Farhi, 2007. "Capital Taxation and Ownership when Markets are Incomplete," NBER Working Papers 13390, National Bureau of Economic Research, Inc.
  2. James D. Hamilton & Marjorie A. Flavin, 1985. "On the Limitations of Government Borrowing: A Framework for Empirical Testing," NBER Working Papers 1632, National Bureau of Economic Research, Inc.
  3. Gorostiaga Alonso, Miren Arantzazu, 2002. "Should Fiscal Policy be different in a Non-Competitive Framework?," DFAEII Working Papers 2002-28, University of the Basque Country - Department of Foundations of Economic Analysis II.
  4. Trehan, Bharat & Walsh, Carl E, 1991. "Testing Intertemporal Budget Constraints: Theory and Applications to U.S. Federal Budget and Current Account Deficits," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(2), pages 206-23, May.
  5. Gorostiaga, Arantza, 2003. "Should fiscal policy be different in a non-competitive framework?," Journal of Monetary Economics, Elsevier, vol. 50(6), pages 1311-1331, September.
  6. Elisa Faraglia & Albert Marcet & Andrew Scott, 2007. "Fiscal Insurance and Debt Management in OECD Economies," Working Papers 333, Barcelona Graduate School of Economics.
  7. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity in the Macroeconomy," GSIA Working Papers 1997-37, Carnegie Mellon University, Tepper School of Business.
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  10. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," Departmental Working Papers 200105, Rutgers University, Department of Economics.
  11. S. Rao Aiyagari & Albert Marcet & Thomas J. Sargent & Juha Seppala, 2002. "Optimal Taxation without State-Contingent Debt," Journal of Political Economy, University of Chicago Press, vol. 110(6), pages 1220-1254, December.
  12. John Heaton & Deborah Lucas, 1993. "Evaluating the Effects of Incomplete Markets on Risk Sharing and Asset Pricing," NBER Working Papers 4249, National Bureau of Economic Research, Inc.
  13. Huw Lloyd-Ellis & Xiaodong Zhu, 2000. "Fiscal Shocks and Fiscal Risk Management," Cahiers de recherche CREFE / CREFE Working Papers 108, CREFE, Université du Québec à Montréal.
  14. Chari, V V & Christiano, Lawrence J & Kehoe, Patrick J, 1991. "Optimal Fiscal and Monetary Policy: Some Recent Results," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 519-39, August.
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  16. International Monetary Fund, 1995. "The Role of Foreign Currency Debt in Public Debt Management," IMF Working Papers 95/21, International Monetary Fund.
  17. Elisa Faraglia & Albert Marcet & Andrew Scott, 2008. "In Search of a Theory of Debt Management," Working Papers 348, Barcelona Graduate School of Economics.
  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.
  19. Scott, Andrew, 1999. "Does Tax Smoothing Imply Smooth Taxes?," CEPR Discussion Papers 2172, C.E.P.R. Discussion Papers.
  20. John Y. Campbell & Robert J. Shiller, 1996. "A Scorecard for Indexed Government Debt," NBER Working Papers 5587, National Bureau of Economic Research, Inc.
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  24. Olivier Blanchard & Roberto Perotti, 1999. "An Empirical Characterization of the Dynamic Effects of Changes in Government Spending and Taxes on Output," NBER Working Papers 7269, National Bureau of Economic Research, Inc.
  25. 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.
  26. Bohn, Henning, 1990. "Tax Smoothing with Financial Instruments," American Economic Review, American Economic Association, vol. 80(5), pages 1217-30, December.
  27. V. V. Chari & Patrick J. Kehoe, 1998. "Optimal fiscal and monetary policy," Staff Report 251, Federal Reserve Bank of Minneapolis.
  28. Christopher Sleet, 2004. "Optimal Taxation with Private Government Information," Review of Economic Studies, Wiley Blackwell, vol. 71(4), pages 1217-1239, October.
  29. 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.
  30. Bernheim, B Douglas, 1991. "Optimal Fiscal and Monetary Policy: Some Recent Results," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 23(3), pages 540-42, August.
  31. Francisco Buera & Juan Pablo Nicolini, 2000. "Optimal Maturity of Government Debt with Incomplete Markets," Econometric Society World Congress 2000 Contributed Papers 1769, Econometric Society.
  32. Scott, Andrew, 2007. "Optimal taxation and OECD labor taxes," Journal of Monetary Economics, Elsevier, vol. 54(3), pages 925-944, April.
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  34. Missale, Alessandro, 1999. "Public Debt Management," OUP Catalogue, Oxford University Press, number 9780198290858.
  35. Cochrane, John H, 1988. "How Big Is the Random Walk in GNP?," Journal of Political Economy, University of Chicago Press, vol. 96(5), pages 893-920, October.
  36. Zhu, Xiaodong, 1992. "Optimal fiscal policy in a stochastic growth model," Journal of Economic Theory, Elsevier, vol. 58(2), pages 250-289, December.
  37. John Y. Campbell & Robert J. Shiller, 1996. "A Scorecard for Indexed Government Data," Harvard Institute of Economic Research Working Papers 1758, Harvard - Institute of Economic Research.
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