Government Debt Control: Optimal Currency Portfolio and Payments

Abstract

Motivated by empirical facts, we develop a theoretical model for optimal currency government debt portfolio and debt payments, which allows both government debt aversion and jumps in the exchange rates. We obtain first a realistic stochastic differential equation for public debt and then solve explicitly the optimal currency debt problem. We show that higher debt aversion and jumps in the exchange rates lead to a lower proportion of optimal debt in foreign currencies. Furthermore, we show that for a government with extreme debt aversion it is optimal not to issue debt in foreign currencies. To the best of our knowledge, this is the first theoretical model that provides a rigorous explanation of why developing countries have reduced consistently their proportion of foreign debt in their debt portfolios.