Abstract
I develop a tractable macro model with endogenous asset liquidity to understand monetary–fiscal interactions with liquidity frictions. Agents face idiosyncratic investment risks and meet financial intermediaries in competitive search markets. Asset liquidity is determined by the search friction and the cost of operating the financial intermediaries, and it drives the financing constraints of entrepreneurs (those who have investment projects) and their ability to invest. In contrast to private assets, government bonds are fully liquid and can be accumulated in anticipation of future opportunities to invest. A higher level of real government debt enhances the liquidity of entrepreneurs׳ portfolios and raises investment. However, the issuance of debt also raises the cost of financing government expenditures: a higher level of distortionary taxation and/or a higher real interest rate. A long-run optimal supply of government debt emerges. I also show that a proper mix of monetary and fiscal policies can avoid a deep financial recession.
Highlights
Asset liquidity captures the ease with which financial assets can be traded without strongly affecting their prices
The recent long-lasting world-wide financial crisis has shown that liquidity fluctuations in asset markets can have a huge impact on asset prices and the real economy
This paper studies monetary–fiscal interactions when movements in asset prices and the real economy are driven by endogenous fluctuations in liquidity
Summary
Asset liquidity captures the ease with which financial assets can be traded without strongly affecting their prices. I show that why with liquidity frictions adverse financial shocks can generate deflationary pressures and push nominal interest rates to the ZLB (when the monetary authority follows a simple Taylor rule) In this regard, this paper is a compliment to Eggertsson and Krugman (2012) and Buera and Nicolini (2014). The first is unconventional monetary policy or “Quantitative Easing” (QE).6 Del Negro et al (2011) demonstrate the large impact of liquidity fluctuation on investment and asset prices and how unconventional monetary policies might stabilize the economy The second proposal, such as in Christiano et al (2011) and Woodford (2011), argues that raising government expenditures will not crowd out private consumption when the ZLB binds. I show that public liquidity provision can alter the liquidity of privately issued claims through the endogenous search and matching
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