Long-term Debt and Optimal Policy in the Fiscal Theory of the Price Level
The fiscal theory says that the price level is determined by the ratio of nominal debt to the present value of real primary surpluses. I analyze long-term debt and optimal policy in the fiscal theory. I find that the maturity structure of the debt matters. For example, it determines whether news of future deficits implies current inflation or future inflation. When long term debt is present, the government can trade current inflation for future inflation by debt operations; this tradeoff is not present if the government rolls over short term debt. I solve for optimal debt policies to minimize the variance of inflation. I find cases in which long-term debt helps to stabilize inflation, and I find that the optimal inflation-stabilizing policy produces time series that are surprisingly similar to U.S. surplus and debt time series.
Cochrane, John H. "Long-Term Debt And Optimal Policy In The Fiscal Theory Of The Price Level," Econometrica, 2001, v69(1,Jan), 69-116. citation courtesy of