Government Debt Management: The Long and Short of It

We study optimal debt management and fiscal policy under incomplete nancial markets, assuming a benevolent planner and full commitment. Our aim is to find a simple setup which matches some basic facts of US debt management. In particular, we focus on solving a puzzle concerning why governments issue short term debt. Key is making the empirically plausible assumption that governments only redeem their debt at maturity ("no buy back"). In this case the share of short bonds is large, persistent and not volatile - as in the data. Long bonds provide fiscal insurance but under no buy back create a lumpy redemption prole which induces tax volatility. Issuing short term debt reduces this lumpiness and tax volatility. Short term debt is therefore issued for tax smoothing reasons rather than for their return properties. In order to analyse these models we propose two signicant extensions to the PEA class of computational methods which overcome problems of the near indeterminacy of the portfolio and the large size of the state space and which are suitable for a broad class of models.