Dallal Bendjellal

The paper studies the optimal maturity of risky government debt when the latter is held by domestic bankers. In economies where financial intermediaries hold large stocks of their government’s debt, swings in bond prices affect not only the debt borrowing costs but also the functioning of the domestic financial system, and subsequently domestic activity. It has been shown in the literature that short-term public debt is associated with high rollover risk and fiscal externalities (i.e. sensitivity of tax rates) but low borrowing costs. Long-term debt, in contrast, is associated with a hedging benefit but high borrowing costs. The latter reflect the higher price risk of long-term bonds, that is borne by the domestic bankers holding these assets and financing the productive sector on the other hand. The model in this paper aims to capture these interactions in order to study how the maturity of debt and the tax rate should adjust to an adverse sovereign risk shock.