Discussion Paper Details

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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): Bayesian estimation, business cycles, Fiscal policy, HANK, incomplete markets and liquidity premium

Programme Area(s): Monetary Economics and Fluctuations

Abstract: We provide evidence that expansionary fiscal policy lowers the return difference between more and less liquid assets---the liquidity premium. We rationalize this finding in an estimated heterogeneous-agent New-Keynesian (HANK) model with incomplete markets and portfolio choice, in which public debt affects private liquidity. In this environment, the short-run fiscal multiplier is amplified by the countercyclical liquidity premium. This liquidity channel stabilizes investment and crowds in consumption. We then quantify the long-run effects of higher public debt, and find a sizable decline of the liquidity premium, increasing the fiscal burden of debt, but little crowding out of capital.

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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.