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The social value of risk-free government debt

  • Stacey L. Schreft
  • Bruce D. 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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Paper provided by Federal Reserve Bank of Kansas City in its series Research Working Paper with number RWP 03-02.

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Date of creation: 2003
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Handle: RePEc:fip:fedkrw:rwp03-02
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  1. 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.
  2. Aiyagari, S. Rao & McGrattan, Ellen R., 1998. "The optimum quantity of debt," Journal of Monetary Economics, Elsevier, vol. 42(3), pages 447-469, October.
  3. Smith, B.D. & Villamil, A.P., 1991. "Government Borrowing using Bonds with Randomly Determined Returns : Welfare Improving Randomization in the Context of Deficit Finance," RCER Working Papers 287, University of Rochester - Center for Economic Research (RCER).
  4. 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.
  5. V. V. Chari & Patrick J. Kehoe, 1998. "Optimal fiscal and monetary policy," Staff Report 251, Federal Reserve Bank of Minneapolis.
  6. George J. Hall & Stefan Krieger, 2000. "Tax Smoothing Implications of the Federal Debt Paydown," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 31(2), pages 253-302.
  7. Kocherlakota, Narayana R., 2003. "Societal benefits of illiquid bonds," Journal of Economic Theory, Elsevier, vol. 108(2), pages 179-193, February.
  8. Villamil, Anne P., 1988. "Price discriminating monetary policy : A nonuniform pricing approach," Journal of Public Economics, Elsevier, vol. 35(3), pages 385-392, April.
  9. Stacey L. Schreft & Bruce D. Smith, 2001. "The conduct of monetary policy with a shrinking stock of government debt," Research Working Paper RWP 01-09, Federal Reserve Bank of Kansas City.
  10. Caporale, Tony & Grier, Kevin B, 2000. "Political Regime Change and the Real Interest Rate," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 320-34, August.
  11. Bruce D. Smith, 2003. "Taking intermediation seriously," Proceedings, Federal Reserve Bank of Cleveland, pages 1319-1377.
  12. Thomas J. Sargent & Neil Wallace, 1981. "Some unpleasant monetarist arithmetic," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall.
  13. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
  14. 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.
  15. Bhattacharya, Joydeep & Guzman, Mark G. & Smith, Bruce D., 1998. "Some Even More Unpleasant Monetarist Arithmetic," Staff General Research Papers 5084, Iowa State University, Department of Economics.
  16. Romer, David, 1993. "Why Should Governments Issue Bonds?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 25(2), pages 163-75, May.
  17. Beatrix Paal & Bruce D. Smith, 2001. "The sub-optimality of the Friedman rule and the optimum quantity of money," IEHAS Discussion Papers 0113, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences.
  18. Townsend, Robert M, 1987. "Economic Organization with Limited Communication," American Economic Review, American Economic Association, vol. 77(5), pages 954-71, December.
  19. Andrew B. Abel & N. Gregory Mankiw & Lawrence H. Summers & Richard J. Zeckhauser, 1986. "Assessing Dynamic Efficiency: Theory and Evidence," NBER Working Papers 2097, National Bureau of Economic Research, Inc.
  20. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  21. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-88, May.
  22. 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.
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