Public debt structure and liquidity provision

Abstract

This study examines the optimal public debt structure when governments can issue multiple assets, the state's fiscal capacity is uncertain, public debt has a liquidity purpose for domestic investors, and public debt markets are open to foreign investors. The optimal policy is to tranch the risky fiscal capacity and then to issue state-contingent assets that pay only when the need for aggregate liquidity in the economy is high. In this way, governments can minimize wasted liquidity of public assets: unused returns on public assets not required by domestic investors. This minimizes the cost of liquidity hoarding for the domestic private sector, which increases investment and welfare in the economy. This study also provides a framework to analyze relevant comparative statics regarding the ownership of state-contingent public assets. In particular, the model assesses the effects of changes in the domestic liquidity needs, the state's fiscal capacity, and the foreign willingness to pay for public debt on the ownership of state-contingent public assets.