Government Debt Management: The Long and the Short of It

Elisa Faraglia, University of Cambridge and CEPR, Albert Marcet, Institut d'Anàlisi Econòmica-CSIC, ICREA, Barcelona GSE, UAB, MOVE and CEPR, Rigas Oikonomou, Université Catholique de Louvain, and Andrew Scott, London Business School and CEPR
Posted on October 8, 2018

Standard optimal Debt Management (DM) models prescribe a dominant role for long bonds
and advocate against issuing short bonds. They require very large positions in order to complete
markets and assume each period that governments repurchase all outstanding bonds and reissue
(r/r) new ones. These features of DM are inconsistent with US data. We introduce incomplete
markets via small transaction costs which serves to make optimal DM more closely resemble
the data : r/r are negligible, short bond issuance substantial and persistent and short and long
bonds positively co-vary. Intuitively long bonds help smooth taxes over states and short bonds
over time. Solving incomplete market models with multiple assets is challenging so a further
contribution of this paper is introducing a novel computational method to fi nd global solutions.

Advance access at OUP

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