Abstract

We construct a dynamic general equilibrium model where agents use nominal government bonds as collateral in secured lending arrangements. If the collateral constraint binds, agents price in a liquidity premium on bonds that lowers the real rate on bonds. In equilibrium, the price level is determined according to the fiscal theory of the price level. However, the market value of government debt exceeds its fundamental value. We then examine the dynamic properties of the model and show that the market value of the government debt can fluctuate even though there are no changes to current or future taxes or spending. The price dynamics are driven solely by the liquidity premium on the debt.

Highlights

  • The ...scal theory of the price is a controversial idea that states that ...scal policy, not monetary policy, pins down the aggregate price level

  • We show that if the real value of the government debt is su¢ciently high, there is no liquidity premium on the debt and the price level is pinned down in the usual way by the ...scal theory of the price level

  • The reason is that by raising the fundamental value of government debt, the real value of current debt increases which loosens the collateral constraints in the DM, which in turn lead to an increase in secured lending and consumption of goods

Read more

Summary

Introduction

The ...scal theory of the price is a controversial idea that states that ...scal policy, not monetary policy, pins down the aggregate price level. Its market value may include a liquidity premium that re‡ects its value for trading in addition to serving as a claim on the stream of future surpluses This suggests that price level movements may be driven by changes in the liquidity value of government debt rather than changing expectations of ...scal policy. If the real value of government debt is su¢ciently low, collateral constraints bind and the price of government debt re‡ects a liquidity premium on the debt In this case, the market value of government debt exceeds its "fundamental value" which is the discounted stream of future surpluses. An increase in future taxes or a cut in government spending, raises the fundamental value of the government debt and the real value of the debt This leads to an expansion of economic activity via an increase in secured lending. Our model can help understand observed movements in the price level when there appears to be no change in perceived ...scal policy

Environment
Decentralized Allocation
CM Trade
DM Trade
Equilibrium
Discussion
Dynamics of Debt
Dynamics for any S
Examples
Conclusion
Full Text
Published version (Free)

Talk to us

Join us for a 30 min session where you can share your feedback and ask us any queries you have

Schedule a call