DP11181 Union Debt Management

Author(s): Juan Equiza-Goni, Elisa Faraglia, Rigas Oikonomou
Publication Date: March 2016
Keyword(s): Debt Management, Fiscal policy, Government Debt, Maturity Structure, Tax Smoothing
JEL(s): E43, E62, H63
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11181

We study the role of government debt maturity in a monetary union in the absence of fiscal transfers across countries. Our key finding is that fi scal hedging is only possible when spending represents an aggregate shock in the union. In the case of idiosyncratic disturbances in spending it is not possible to target a portfolio which provides fi scal insurance to the governments: the allocation is one of incomplete financial markets. These implications are in line with the empirical evidence. Using a sample of 5 Euro area countries and historical holding period returns on government debt, we find that fiscal insurance is not signifi cant against country speci fic shocks however, it is signifi cant against aggregate shocks. Our analysis extends the theoretical results of the literature on optimal fiscal policy without state contingent debt to a two country model. We show that in the two country setup and under an incomplete market the optimal tax schedule, consumption and leisure follow a random walk.