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Title: The Liquidity Channel of Fiscal Policy

Author(s): Christian Bayer, Benjamin Born and Ralph Luetticke

Publication Date: June 2020

Keyword(s): business cycles, Fiscal policy, HANK, incomplete markets, liquidity premium and public debt

Programme Area(s): Monetary Economics and Fluctuations

Abstract: We provide evidence that expansionary fiscal policy lowers return differences between public debt and less liquid assets---the liquidity premium. We rationalize this finding in an estimated heterogeneous-agent New-Keynesian model with incomplete markets and portfolio choice, in which public debt affects private liquidity. This liquidity channel stabilizes fixed-capital investment. We then quantify the long-run effects of higher public debt and find little crowding out of capital, but a sizable decline of the liquidity premium, which increases the fiscal burden of debt. We show that the revenue-maximizing level of public debt is positive and has increased to 60 percent of GDP post-2010.

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Bibliographic Reference

Bayer, C, Born, B and Luetticke, R. 2020. 'The Liquidity Channel of Fiscal Policy'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=14883