Ebook Debt Maturity in a Small Open Economy under Inflation Target
This paper is motivated by the short term lending bias observed in many emerging market countries, especially in Latin America. We show that when an economy is prone to confidence crises, households rationally demand a premium to compensate for this risk. This raises the cost to a Treasury of borrowing long, and leads to the observed short term debt maturity structure. In order to understand this problem, we study the impact of alternative government debt maturity strategies in a small, open dynamic general equilibrium model. We subject the economy to an exogenous risk premium shock.
The exchange rate depreciates immediately and the Central Bank must increase the interest rate to control inflation. Surprise inflation reduces consumer wealth because it depresses the real return on nominal bonds. This wealth effect is worse when the household holds longer maturity bonds because the foregone return is greater. We show that when an economy is prone to confidence crises, investors will hold longer bonds only if they are compensated for this possible wealth loss. This extra compensation increases the fiscal authority’s borrowing cost, and it in turn reacts by shortening the maturity structure.
We construct an environment a with nominal friction, but note recent work on debt maturity by Angeletos (2002), Buera and Nicolini (2004) and Shin (2006) that consider a classical scenario with fully flexible prices. The first two showed that the optimal allocation can be implemented by carefully choosing the debt maturity, implying that there is no need to rely on state contingent bonds to replicate the optimal allocation of Lucas and Stokey (1983). The optimal maturity is obtained by appropriately issuing bonds of at least as many maturities as the number of states. The result is an optimal maturity that is state invariant, implying that a country’s Treasury would not need to actively manage the maturity structure.
Shin (2006) observed that despite the insight provided by Angeletos and Buera and Nicolini, it is well known that active management is conducted by every Treasury. Shin derived an active debt management strategy that could also implement the optimal allocation, by using a Markov chain with an asymmetric transition matrix to capture how fast government expenditure rises and falls. This matrix is then used to obtain the active maturity strategy with a short term bond and a consol.
Calibration for England, during the 18th century, reveals that Shin’s strategy matches British Treasury policy. He verifies that, during peace times when government consumption was lower, more consols were issued while short period bonds were accumulated. A reverse operation was conducted as war broke out and government spending was “medium”. As war reached its climax and expenditure was higher, the initial situation was again observed, but not necessarily with the same intensity.
Even though we also study debt maturity, the economic environment considered here is different from those of previous authors. In particular, our world is one in which nominal frictions and monetary policy matter. The reason for this is that we wish to consider situations of recent interest, where interest rate movements to control inflation affect the bond returns.
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