This Working Paper should not be reported as representing the views of the IMF. The views expressed in this Working Paper are those of the author(s) and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. The literature on optimal fiscal policy finds that highly volatile real returns on government debt, for example through surprise inflation, have very low costs. However, policymakers are almost always very apprehensive of this option. The paper discusses evidence concerning features of developing country financial markets that are missing in existing models, and that may suggest why this policy is considered so costly in practice. Most importantly, domestic banks choose to be highly exposed to government debt because the alternative, private lending, is more risky under existing legal and institutional imperfections. This exposure makes banks and their borrowers vulnerable to the government's debt policy.
The size of the federal budget deficit has alarmed politicians and the general public both. Following recent work, we examine the long‐run solvency of the U.S. government by testing for cointegration of federal expenditures and revenues. We include a break term in the cointegrating recession for 1981 to capture a shift in the fiscal process in the first Reagan administration. Tests show the break to be significant; and with the break, in contrast to earlier work, expenditures and revenues are cointegrated with a coefficient of one. Thus, we find the deficit to be stationary and so potentially sustainable.
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