A Taylor Rule for Public Debt

Public debt is an important source of liquidity in economies facing shortages of private credit. It is also a bubble whose current price depends on expectations of what it will buy at future dates. In this article, the author studies how the government must balance the provision of sufficient liquidity against the risk of adverse expectations regarding future debt prices when private liquidity has dried up. The socially optimal balance is captured in a Taylor-like rule that sets a target for real public debt and manages expectations by overreacting to deviations from the target value. Overreaction takes the form of manipulating budget surpluses to absorb excess debt or reverse liquidity shortages. A budget surplus (deficit) is equivalent to an income tax (subsidy) on investors that restrains (raises) their demand for liquid assets.