Monetary-fiscal Interactions with Endogenous Liquidity Frictions [paper],
lead article, European Economic Review, 2016
This paper develops a New Keynesian model in which government debt is valued not only as a claim to future resources, but also for the liquidity services it provides. Private claims on capital are imperfectly saleable because they are traded through frictional financial markets, whereas government bonds are fully liquid. Agents therefore accumulate government bonds as a buffer against idiosyncratic investment opportunities. A larger supply of real government debt improves portfolio liquidity, relaxes entrepreneurs’ financing constraints, crowds in investment, and affects the liquidity premium on private assets.
This mechanism makes government debt non-neutral. Monetary–fiscal interactions operate not only through the government’s intertemporal budget constraint, but also through the supply of public liquidity, private balance sheets, and aggregate demand. In the terminology of the recent literature, the paper provides a financing-constraint foundation for non-Ricardian fiscal effects: public debt affects current real allocations because it provides liquidity services. This mechanism is distinct from—and complementary to—the finite-horizon or high-MPC household channels commonly used in modern HANK models.
Public liquidity is beneficial but costly. Additional debt supports investment, but financing it requires higher distortionary taxation and/or a higher real interest rate. This tradeoff generates an optimal long-run supply of government debt. Following adverse financial shocks, monetary and fiscal policy must be designed jointly because both policies affect asset liquidity, financing constraints, and the severity of the resulting recession.
Unlike imperfectly saleable private claims, government bonds provide public liquidity. Entrepreneurs can accumulate them before investment opportunities arrive, so a larger stock of government debt relaxes financing constraints (e.g., used as collateral) and raises investment.
Government debt is not neutral because it changes the liquidity composition of private portfolios and therefore current investment and aggregate demand. This provides a distinct microfoundation for non-Ricardian monetary–fiscal interactions—one based on incomplete insurance and financing constraints.
More government debt supplies useful liquidity, but it must ultimately be supported by taxation or higher real interest rates. This produces an optimal long-run debt supply and makes monetary–fiscal coordination essential during financial recessions.