Why Do We Have Nominal Government Debt?

The time-consistency literature suggests that there is no reason to have anything but indexed debt. We show that nominal debt provides valuable insurance against the financial effects of economic fluctuations and variations in government expenditures. Even though there are incentives for the government to manipulate the price level, which imply that high nominal debt raises expected inflation, it is not optimal to issue only indexed debt. The reason is that, at the point of zero nominal debt, the cost of “wrong” incentives are of a lower order of magnitude than the gains from hedging against economic shocks. These issues are first analyzed in a simple macroeconomic model in which we derive the economic structure and the welfare function from individual preferences. The setting is one of discretionary policy, where the government sets taxes and the money supply every period but is committed to honoring debt. We generalize the results in various directions. They are fairly robust with respect to changes in assumptions on the policy setting. The hedging argument also holds up in more general macroeconomic models: shocks to the supply side and effects due to shifts of the Phillips-curve exert additional influences on the optimal amount of nominal debt. We outline how the approach could be applied to long term debt and foreign currency bonds. For both types of securities, similar arguments as for nominal bonds apply.