The effects of secondary markets for government bonds on inflation dynamics

Abstract

We analyze how trading in secondary markets for public debt changes the inherent links between monetary and fiscal policy, by studying both inflation and debt dynamics. When agents do not trade in these markets, there exists a unique monetary steady state and traditional passive/active policy prescriptions deliver locally determinate equilibria. In contrast, when agents trade in secondary markets and bonds are scarce, there exists a liquidity premium on public debt and bonds affect inflation dynamics and vice versa. In this monetary equilibrium, the government budget constraint can be satisfied for different combinations of inflation and debt. Thus, self-fulfilling beliefs that deliver multiple steady states are possible. Moreover, traditional passive/active policy prescriptions are not always useful in delivering locally determinate equilibria. However, monetary and fiscal policies can be used as an equilibrium selection device. We find that active monetary policies are more likely to deliver real and nominal determinacy when the long-run inflation target is low.