Public debt bubbles in general equilibrium with outside liquidity

Martins-da-Rocha, Victor Filipe
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This paper explores the possibility of public debt bubbles in dynamic asset markets with limited commitment and public goods. We construct Markovian equilibria with negative interest rates where government debt improves risk sharing and can be sustained by means of a super bubble. In our financially constrained economy, public debt plays two distinct roles: improving risk sharing and financing the provision of a public good. There is a trade-off between the two policy objectives. It might not be optimal to fully mine the debt bubble because doing so might harm the market’s liquidity provision. Finally, government can freely set the tax rate, first best can be implemented as an equilibrium outcome.

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