Paper #558

Title:

Debt and deficit fluctuations and the structure of bond markets

Authors:

Albert Marcet and Andrew Scott

Date:

May 2001 (Revised: July 2003)

Abstract:

This paper tests for the market environment within which US fiscal policy operates, that is we test for the incompleteness of the US government bond market. We document the stochastic properties of US debt and deficits and then consider the ability of competing optimal tax models to account for this behaviour. We show that when a government pursues an optimal tax policy and issues a full set of contingent claims, the value of debt has the same or less persistence than other variables in the economy and declines in response to higher deficit shocks. By contrast, if governments only issue one-period risk free bonds (incomplete markets), debt shows more persistence than other variables and it increases in response to expenditure shocks. Maintaining the hypothesis of Ramsey behavior, US data conflicts.

Keywords:

Optimal fiscal policy, complete vs incomlete markets, tax smoothing, government debt, persistence of debt

JEL codes:

E62, E17

Area of Research:

Macroeconomics and International Economics

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