Discussion paper
DP15488 Public Debt as Private Liquidity: Optimal Policy
We study optimal policy in an economy in which public debt
is used as collateral or liquidity buffer. Issuing more public debt
raises welfare by easing the underlying financial friction; but this
easing lowers the liquidity premium and increases the government's
cost of borrowing. These considerations, which are absent in the basic
Ramsey paradigm, help pin down a unique, long-run level of public
debt. They require a front-loaded tax response to government-spending
shocks, instead of tax smoothing. And they explain why a financial
recession, more than a traditional one, makes government borrowing
cheaper, optimally supporting larger fiscal stimuli.
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