Monetary and fiscal policy interactions in a frictional model of fiat money, nominal public debt and banking

Abstract

In this paper, we study the interactions between fiscal and monetary policy in a frictional economy where fiat money, bank deposits and short-term and long-term nominal government bonds coexist. Since agents face information frictions and bankers have limited commitment, bank deposits need to be collateralized with nominal public debt. These bank deposits can only be used as payment instruments in some states, while fiat money is always accepted. Within this frictional environment, we study monetary and fiscal policy interactions under different policy stances. When the monetary authority follows an active policy regime, a unique stationary equilibrium exists regardless of how the supply of the various nominal government bonds is specified. Under this policy regime, we also find that consumption inequality increases when the central bank pursues an expansionary monetary policy. In contrast, when the fiscal authority pursues active policies, real indeterminacies can exist. However, when the fiscal authority issues sufficiently few long-term (or short-term) bonds, a unique steady state exists. We also identify cases where an expansionary fiscal policy leads to a decline in consumption inequality between money transactions and deposit-backed transactions. Finally, regardless of the policy regime chosen by the government, financial innovations alter the relative demand for public debt and do not always lead to an increase in welfare. The financial innovations alter the underlying monetary and fiscal policy interactions and consumption inequality.