Long Term Government Bonds

We study how the issuance of long bonds affects optimal fiscal policy. Long bonds are usually modelled as having two features that are not found in the data: a) zero coupons and b) previously issued bonds are repurchased each period regardless of their time to maturity. The literature has found that under a) and b) issuing long bonds provides fiscal insurance. We show that these assumptions are not innocuous. Specifically we find that long bonds may not complete the markets even in the absence of uncertainty and under certain assumptions long bonds introduce additional tax volatility that offsets the attractiveness they provide through fiscal insurance. We find that introducing coupons helps alleviate the additional tax volatility but does so by reducing the ability of long bonds to provide insurance. Under full commitment the government promises future tax changes in order to reduce current funding costs. This introduces additional tax volatility. If we remove assumptions a) and b) interest rate twisting takes a very different form, showing again that those assumptions matter.