Abstract
The government faces a trade‐off between the benefits of tax smoothing and an associated increase in expected interest costs when choosing its optimal debt portfolio. The article solves for optimal policies in an incomplete markets model where the government uses two debt instruments, long‐term and short‐term non‐contingent, nominal bonds. In this setup the basic prescription is to borrow long and invest short even though equilibrium expected interest costs are higher on long‐term debt. The resulting welfare gains are close to what the government could achieve with complete markets. Significant welfare gains are possible even in the presence of leverage constraints.
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