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Collateral, Liquidity and Debt Sustainability

  • Stefan Niemann

    ()

    (Department of Economics, University of Essex, United Kingdom.)

  • Paul Pichler

    ()

    (Economic Studies Division, Oesterreichische Nationalbank, Austria)

We study the sustainability of public debt in a closed production economy where a benevolent government chooses scal policies, including haircuts on its outstanding debt, in a discretionary manner. Government bonds are held by domestic agents to smooth consumption over time and because they provide collateral and liquidity services. We characterize a recursive equilibrium where public debt amounts to a sizeable fraction of output in steady state and is nevertheless fully serviced by the government. In a calibrated economy, steady state debt amounts to around 84% of output, the government's default threshold is at around 94% of output, and the haircut on outstanding debt at this threshold is around 40%. Both reputational costs of default and contemporaneous costs due to lost collateral and liquidity are essential to generate these empirically plausible predictions.

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Paper provided by Oesterreichische Nationalbank (Austrian Central Bank) in its series Working Papers with number 187.

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Length: 53
Date of creation: 30 Dec 2013
Date of revision:
Handle: RePEc:onb:oenbwp:187
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  19. 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.
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