In the presence of nominal debt, a government's inability to commit to future policy choices is a fundamental friction that provides an explanation for: the level of debt; how policy reacts to government expenditure shocks; and why cross-country di_erences in debt are so untractable.
The long-run level of debt is the result of a trade-o_. On the one hand, there is an incentive to increase debt and delay taxation, so as to reduce current distortions. On the other hand, inating current prices lowers the real value of nominal debt and so there is a motive to reduce it now. This trade-o_ generates a level of long-run debt that is interior and independent of initial debt. The sign and size of long-run debt will depend on how the incentives to increase and decrease debt play out against each other. The critical determinant is how easy or di_cult it is for households to substitute away from goods being taxed by ination. The model is consistent with two seemingly conicting empirical observations. It allows for economies that feature very di_erent macroeconomic fundamentals, to have similar levels of government debt and at the same time for economies that share some similar important fundamentals, to di_er substantially in their level of government debt. The model provides sharp predictions for which fundamentals allow for the di_erences and the similarities between countries. The model performs better than Ramsey-type models in terms of the volatility and autocorrelation of policy variables. It also is consistent with the fact that wars are frequently _nanced with a mix of instruments. The theory suggests that the unusual post-World War II ination and fast liquidation of accumulated debt was due to higher long-run debt and expenditure in the period leading up to the war.