Nominal GDP growth indexed bonds: Business Cycle and Welfare Effects within the Framework of New Keynesian DSGE model

We examine the welfare effects of GDP-indexed bonds in a New Keynesian DSGE model. We add to a literature showing that the issuance of GDP-indexed bond may help stabilise public debt and so give more room for countercyclical fiscal policy, by conducting a careful general equilibrium welfare analysis. In a standard DSGE models, where Ricardian equivalence holds, household welfare is immune to the source of government financing. We examine how GDP-indexed bonds, rather than nominal bonds, affect welfare when Ricardian equivalence does not hold. Specifically, we add “hand-to-mouth” households (Galí et al., 2007), distortionary income taxes that fund debt, and Epstein and Zin (1989) type recursive preference to the most widely used medium scale model of Smets and Wouters (2007). The results show when the fiscal authority tries to stabilise debt, GDP-indexed bonds can significantly increase the welfare of the hand-to-mouse households by stabilising their consumption and labour supply responses to fiscal consolidations compared to a case involving nominal debt alone.