Optimal public debt indexation in advanced economies

Abstract

Abstract This article examines the cross-country heterogeneity in the share of advanced economies’ inflation-linked (IL) debt when governments, taking inflation as given, issue IL debt and nominal debt and aim to minimize tax distortions, debt investors are risk-neutral, and nominal debt carries a convenience premium. The optimal IL debt share increases in the level and the variance of inflation, decreases in the correlation between government spending and inflation, and, for a fixed level of debt, decreases in the nominal debt’s convenience premium. Data between 1995 and 2018 for 14 advanced economies that issue IL debt exhibit cross-country correlations in line with the model’s comparative statics about inflation. The model’s welfare analysis suggests that nominal debt’s convenience premium can explain the relatively low public debt indexation in most advanced economies.