Government as borrower of first resort.

Summary We examine optimal supply of safe government bonds accounting for their effect on corporate debt markets. Government bonds are shown to influence leverage under asymmetric information regarding corporate cash flows and safe asset scarcity. Corporations have incentives to issue junk debt in response to safe asset scarcity since uninformed investors then migrate to junk debt markets. Uninformed demand stimulates informed speculation which drives junk debt prices closer to fundamentals, encouraging pooling at high leverage. Acting as borrower of first resort, the government can issue safe bonds which siphon off uninformed demand for risky corporate debt and reduce socially wasteful informed speculation. Thus, government bonds either eliminate pooling at high leverage or improve risk sharing in such equilibria. An optimal supply of government bonds is increasing in both marginal Q and the intrinsic demand for safe assets.