Optimal Maturity of Government Debt without State Contingent Bonds

This paper shows that state contingent debt can be syntethically constructed using non-contingent debt of di¤erent maturities. A main policy implication of this principle is that the Ramsey allocation with complete markets can be sustained with non-contingent debt only by properly managing its maturity structure. The numerical experiments, however, suggest that this policy implication ought to be taken with care. We …nd that the debt positions that sustain the Ramsey allocation are very high (on the order of a few hundred times total GDP for a very simple four state economy) and increasing in the number of states. In addition, they are very sensitive to small variations in the parameters of the model. Corresponding author: Juan P. Nicolini. Department of Economics, Universidad Torcuato Di Tella, Miñones 2159, Capital Federal, 1428. Argentina. Tel: 54-11-4784-0080. Fax: 54-11-4784-0089. E-mail: [email protected]. yWe started working on this project after a lively discussion on a presentation of an earlier paper of ours in a conference on Incomplete Markets organized by the Federal Reserve Bank of Minneapolis. We want to thank the participants for the discussion. We also want to thank two referees, Fernando Alvarez, Christian Broda, Albert Marcet, Rodi Manuelli, Andy Neumeyer and Iván Werning for helpful conversations. We acknowledge research support from Latin American Research Network of the Inter-American Development Bank. We alone are responsible for shortcomings.