## Government Debt: A Key Role in Financial Intermediation

_IMF Working Papers, March 1, 2005_

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**Canonical URL:** [Government Debt: A Key Role in Financial Intermediation](https://www.imf.org/en/publications/wp/issues/2016/12/31/government-debt-a-key-role-in-financial-intermediation-17984)

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## Bibliographic details
- Authors: Michael Kumhof, Evan C Tanner
- Published: March 1, 2005
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451860764.001

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### Summary
- The literature on optimal fiscal policy finds that highly volatile real returns on government debt, for example through surprise inflation, have very low costs.
- Policymakers are almost always very apprehensive of this option.
- The paper discusses evidence concerning features of developing country financial markets that are missing in existing models, and that may suggest why this policy is considered so costly in practice.
- Most importantly, domestic banks choose to be highly exposed to government debt because the alternative, private lending, is more risky under existing legal and institutional imperfections.
- This exposure makes banks and their borrowers vulnerable to the government's debt policy.

### Findings on financial intermediation and bank behavior
- Domestic banks choose high exposure to government debt.
- Private lending is perceived as more risky in the presence of legal and institutional imperfections.
- Bank exposure to government debt links the banking sector’s balance-sheet risk directly to government debt policy, increasing vulnerability.

### Policy implications and interpretation
- The low theoretical cost of volatile real returns on government debt (e.g., surprise inflation) contrasts with policymakers’ strong aversion to such policies.
- Missing features in standard models—specifically legal and institutional weaknesses in developing-country financial markets—help explain why such policies are considered costly in practice.
- The interaction between government debt policy and banks’ portfolio choices suggests that government debt management affects financial stability through bank balance sheets and borrower vulnerability.

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## Content in this bundle

- **_wp0557 - Appendix I**
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_Source: https://www.imf.org/en/publications/wp/issues/2016/12/31/government-debt-a-key-role-in-financial-intermediation-17984_