DP14883 The Liquidity Channel of Fiscal Policy

Author(s): Christian Bayer, Benjamin Born, Ralph Luetticke
Publication Date: June 2020
Date Revised: April 2021
Keyword(s): business cycles, Fiscal policy, HANK, incomplete markets, liquidity premium, public debt
JEL(s): C11, D31, E21, E32, E63
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=14883

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.