Optimal Supply of Government Bond: Collateralization and Overaccumulation of Capital 

Abstract

When capital serves as a substitute for government debt in the collateral market, a high collateral premium results in an over-accumulation of capital as the firm demands more to relax the collateral requirement. Increasing the debt supply optimally crowds out capital through two channels. First, it reduces the demand for capital by relaxing the collateral requirement. Second, because tax is distorting, a larger volume of debt level increases debt service and tax on capital. The optimal supply of government debt achieves efficient capital allocation. When the production uncertainty increases, a larger volume of government debt is needed to achieve the efficient allocation as agents demand larger amounts of collateral when productivity is more volatile.