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Government Debt: A Key Role in Financial Intermediation

  • Michael Kumhof
  • Evan Tanner

The literature on optimal fiscal policy finds that highly volatile real returns on government debt, for example through surprise inflation, have very low costs. However, policymakers are almost always very apprehensive of this option. The paper discusses evidence concerning features of developing country financial markets that are missing in existing models, and that may suggest why this policy is considered so costly in practice. Most importantly, domestic banks choose to be highly exposed to government debt because the alternative, private lending, is more risky under existing legal and institutional imperfections. This exposure makes banks and their borrowers vulnerable to the government's debt policy.

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Paper provided by International Monetary Fund in its series IMF Working Papers with number 05/57.

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Length: 29
Date of creation: 01 Mar 2005
Date of revision:
Handle: RePEc:imf:imfwpa:05/57
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  1. 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.
  2. La Porta, Rafael & Lopez-de-Silanes, Florencio & Shleifer, Andrei & Vishny, Robert W., 1998. "Law and Finance," Scholarly Articles 3451310, Harvard University Department of Economics.
  3. 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.
  4. Carmen M. Reinhart & Graciela L. Kaminsky, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June.
  5. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," Departmental Working Papers 200105, Rutgers University, Department of Economics.
  6. Richard J. Herring & Nathporn Chatusripitak, 2000. "The Case of the Missing Market: The Bond Market and Why It Matters for Financial Development," Center for Financial Institutions Working Papers 01-08, Wharton School Center for Financial Institutions, University of Pennsylvania.
  7. Guillermo A. Calvo & Carlos A. Végh, 1990. "Interest Rate Policy in a Small Open Economy: The Predetermined Exchange Rates Case," IMF Staff Papers, Palgrave Macmillan, vol. 37(4), pages 753-776, December.
  8. V. V. Chari & Patrick J. Kehoe, 1999. "Optimal Fiscal and Monetary Policy," NBER Working Papers 6891, National Bureau of Economic Research, Inc.
  9. Buera, Francisco & Nicolini, Juan Pablo, 2004. "Optimal maturity of government debt without state contingent bonds," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 531-554, April.
  10. Chari, V V & Christiano, Lawrence J & Kehoe, Patrick J, 1994. "Optimal Fiscal Policy in a Business Cycle Model," Journal of Political Economy, University of Chicago Press, vol. 102(4), pages 617-52, August.
  11. Reinhart, Carmen & Rogoff, Kenneth & Savastano, Miguel, 2003. "Debt intolerance," MPRA Paper 13932, University Library of Munich, Germany.
  12. Michael Kumhof, 2004. "Fiscal Crisis Resolution: Taxation Versus Inflation," 2004 Meeting Papers 874, Society for Economic Dynamics.
  13. Vincent Reinhart & Brian Sack, 2000. "The Economic Consequences of Disappearing Government Debt," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 31(2), pages 163-220.
  14. Calvo, Guillermo A, 1978. "On the Time Consistency of Optimal Policy in a Monetary Economy," Econometrica, Econometric Society, vol. 46(6), pages 1411-28, November.
  15. Michael J. Flemming, 2000. "Financial Market Implications of the Federal Debt Paydown," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 31(2), pages 221-252.
  16. World Bank & International Monetory Fund, 2001. "Developing Government Bond Markets : A Handbook," World Bank Publications, The World Bank, number 13865.
  17. Michael J. Fleming, 2001. "Financial market implications of the federal debt paydown," Staff Reports 120, Federal Reserve Bank of New York.
  18. repec:idb:brikps:34698 is not listed on IDEAS
  19. Siu, Henry E., 2004. "Optimal fiscal and monetary policy with sticky prices," Journal of Monetary Economics, Elsevier, vol. 51(3), pages 575-607, April.
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