Discussion Paper Details

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Title: Joined at the hip: monetary and fiscal policy in a liquidity-dependent world

Author(s): Guillermo Calvo and Andrés Velasco

Publication Date: March 2022

Keyword(s): Fiscal policy, liquidity, monetary policy and quantative easing

Programme Area(s): International Macroeconomics and Finance and Monetary Economics and Fluctuations

Abstract: We study the effects of monetary and fiscal policies when both money and government bonds provide liquidity services. Because money is the unit of account, the price of money is the inverse of the price level. If prices are sticky, so is the price of money in terms of goods, and this is one important reason why money is liquid and attractive. By contrast, the price of government bonds is free to jump and often does, especially in response to news about changes in fiscal policy and the supply of bonds. Those movements in government bond prices affect available liquidity, and therefore aggregate demand, inflation and output. Under these conditions, bond-financed fiscal expansions can be contractionary, causing deflation and a temporary recession. To avoid those effects, changes in bond supply must be matched by changes in money supply and in the interest rate on money. We conclude that in a liquidity-dependent world, fiscal and monetary policies are joined at the hip.

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Bibliographic Reference

Calvo, G and Velasco, A. 2022. 'Joined at the hip: monetary and fiscal policy in a liquidity-dependent world'. London, Centre for Economic Policy Research.