DP18197 Government Debt Management and Inflation with Real and Nominal Bonds
Can governments use TIPS to tame inflation? We propose a novel framework of optimal debt management with sticky prices and a government that issues nominal and real state-uncontingent bonds. Nominal debt can be monetized giving ex-ante flexibility, whereas real bonds are cheaper but constitute a commitment ex-post. Under Full Commitment, the government chooses a leveraged portfolio of nominal liabilities and real assets to use inflation to smooth taxes. With No Commitment, it reduces borrowing costs ex-ante using real debt strategically to prevent future governments from monetizing debt ex-post. Such policies match U.S. data, with higher TIPS shares effectively curbing inflation.