Abstract:
This paper incorporates a bubble term in the standard FTPL equation to explain why countries with persistently negative primary surpluses can have a positively valued currency and low inflation. It also provides two illustrative models with closed-form solutions in which the return on government bonds is below the economy’s growth rate. The government can “mine” the bubble by perpetually rolling over its debt. The welfare maximizing bubble mining rate is independent of government spending, and additional spending needs should be financed exclusively through taxes. Despite the bubble, the price level remains determined provided government policy credibly promises primary surpluses off-equilibrium.