Dealing with Maturity : Solving for Optimal Fiscal Policy in the Case of Long Bonds

We study how to model optimal …scal policy in the case where the government issues long bonds. We propose a ‡exible numerical method that can be used to solve this problem at low computational cost by substantially reducing the required state space. This numerical method enables us to maintain a rich economic structure and avoids restrictive assumptions or approximatons about the economy, bond markets, maturity structure or the nature of bonds that other authors have had to make to consider this problem. Our computational method has much wider applicability than just Ramsey models of debt management. We analyse the reasons behind the complexity of optimal …scal policy with long bonds and show that it arises from the temptation to manipulate interest rates and taxes to reduce funding costs in the case of non-zero initial debt. In other words, debt management concerns override tax smoothing considerations. We therefore propose an alternative means of simplifying the problem by considering a model of independent powers where interest rates are set by a monetary authority and debt issued by the …scal authority. Finally the introduction of long bonds raises important issues about what the government does at the end of every period with outstanding debt. We show how to model the case of no buyback, where debt is left to maturity. We once again …nd governments with an incentive to manipulate interest rates and taxes and for debt management to override tax smoothing. JEL Classi…cation : C63, E43, E62, H63