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Interest Costs and the Optimal Maturity Structure Of Government Debt


  •  This article is based on Chapter 2 of my Ph.D. dissertation at Harvard University. I am grateful to John Campbell for his advice and suggestions. I also thank Robert Barro, Jens Hilscher, N. Gregory Mankiw, Albert Marcet, Emi Nakamura, Ricardo Reis, Kenneth Rogoff, Andrew Scott, Jeremy Stein, Jón Steinsson and seminar participants at Harvard, the London School of Economics, the London Business School, Oxford, HEC Paris, the European Central Bank, Insead, the Federal Reserve Board of Governors, Boston University and the 2007 Annual Conference of the Royal Economic Society for helpful comments and discussions.


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.