NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Fiscal Hedging and the Yield Curve

Hanno Lustig, Christopher Sleet, Sevin Yeltekin

NBER Working Paper No. 11687
Issued in October 2005
NBER Program(s):Economic Fluctuations and Growth, Monetary Economics, Asset Pricing, Public Economics

We identify a novel, fiscal hedging motive that helps to explain why governments issue more expensive, long-term debt. We analyze optimal fiscal policy in an economy with distortionary labor income taxes, nominal rigidities and nominal debt of various maturities. The government in our model can smooth labor tax rates by changing the real return it pays on its outstanding liabilities. These changes require state contingent inflation or adjustments in the nominal term structure. In the presence of nominal pricing rigidities and a cash in advance constraint, these changes are themselves distortionary. We show that long term nominal debt can help a government hedge fiscal shocks by spreading out and delaying the distortions associated with increases in nominal interest rates over the maturity of the outstanding long-term debt. After a positive spending shock, the government raises the yield curve and steepens it.

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Document Object Identifier (DOI): 10.3386/w11687

Published: Lustig, Hanno, Chris Sleet, and Sevin Yeltekin. "Fiscal Hedging with Nominal Assets." Journal of Monetary Economics 55, 4(2008).

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