Fiscal hedging with nominal assets

This paper solves for optimal fiscal and monetary policy in a fully specified general-equilibrium economy in which the government finances distortionary-tax-smoothed spending only with non-contingent nominal bonds of several maturities – no explicit state-contingent debt is available – and both households and the government face a “no lending” constraint that rules out negative bond positions. Two nominal frictions, borrowed from Siu (2004), give the government’s inflation and interest-rate choices real bite: a fraction of firms must set prices before the current shock is known, so inflation surprises misallocate production across sticky- and flexible-price firms, and households face a cash-in-advance constraint on part of their consumption, so positive short-term nominal interest rates misallocate spending across cash and credit goods. Because explicit contingent claims are unavailable, the government can only hedge adverse fiscal shocks (higher spending or lower productivity) indirectly, through contemporaneous inflation surprises and through changes in the price of its outstanding debt at each maturity, both of which are costly. Solving the Ramsey problem recursively and computing calibrated numerical examples, the paper’s central finding is that optimal policy relies almost exclusively on the longest-maturity nominal bond available: long-term debt lets the government postpone the nominal-interest-rate increases used to hedge a shock, paying the associated transaction-cost distortion later and concentrating it in states where it can hedge several past shocks at once, rather than absorbing the full cost immediately. In the calibrated examples, a spell of adverse fiscal shocks produces a gradual rise in short-term nominal rates and a hump-shaped yield curve with the hump at the longest outstanding maturity, reverting to a flatter, lower curve once the shock spell ends or that debt matures; the resulting volatility in long-term bond returns is deliberate policy, not a cost, and functions like an insurance premium the government pays for hedging rather than a reason to shorten the maturity structure, as some earlier literature (e.g., Barro 1997) had argued while treating inflation and the yield curve as exogenous. The welfare gains from allowing longer maximum maturities, while positive, are found to be quantitatively small (roughly 0.02%-0.1% of consumption).

Şevin Yeltekin | Macro Paper Warehouse

Fiscal hedging with nominal assets