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On the Theory of Public Debt Management

We analyse optimal fiscal policy in an economy with distortionary taxes, nominal rigidities and nominal debt of various maturities. The government in our model can smooth labour tax rates by altering the real return it pays on its outstanding liabilities. Such alterations require state contingent inflations or adjustments in the nominal term structure. In the presence of nominal rigidities in pricing and a cash in advance constraint, these alterations are themselves distortionary. We show that while debt can help a government smooth taxes, long term debt can help a government smooth (and postpone) the costs associated with adjustments to the return it pays on its liabilities.