DP14883 The Liquidity Channel of Fiscal Policy
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.