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Time Consistent Debt

  • Per Krusell
  • Fernando M. Martin
  • Jose-Victor Rios-Rull

In this paper we address the time-inconsistency of optimal debt policy—the incentive for a current government to “manipulate interest ratesâ€â€”raised in Lucas and Stokey’s celebrated 1983 paper. The literature that followed suggested various ways to fully overcome the timeconsistency problem or support the commitment outcome despite the lack of commitment. Perhaps surprisingly, however, there is no analysis of what an equilibrium would look like in the basic model with one-period bonds. The present paper provides this analysis. Our main result is striking: the time series of debt in the economy without commitment is extremely similar (though not identical) to that with commitment, and welfare is very similar as well. This result is surprising: under commitment, there is always an incentive for a once-and-for-all tax cut/debt hike, thus suggesting ever-increasing debt under lack of commitment. However, we show that the incentives that naturally arise in the dynamic game between successive governments actually help limit the time-consistency problem: they lead to very limited debt accumulation, and long-run debt levels can even be lower than under commitment. This incentive mechanism is a result of forward-looking and strategic use of debt and of nonconvexities whose fundamental origin is the disagreement between consecutive governments: the time-consistency problem. We thus learn from our analysis that, in stark contrast to other contexts (e.g, the case of capital income taxation), the time-consistency problems associated with interest-rate manipulation are not as severe as may first appear. The incentives generated by the successive interactions of rational governments all but eliminate the problem, without added instruments—such as a rich maturity structure of the government’s debt portfolio—and without institutional reforms

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Paper provided by Society for Economic Dynamics in its series 2006 Meeting Papers with number 210.

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Date of creation: 03 Dec 2006
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Handle: RePEc:red:sed006:210
Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
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