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

Guillermo A. Calvo and Andres Velasco

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

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.

Keywords: obnd markets; fiscal policy; liquidity; monetary policy (search for similar items in EconPapers)
JEL-codes: B22 E42 E44 E51 E52 E58 E61 (search for similar items in EconPapers)
Pages: 23 pages
Date: 2026-02-24
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Published in Journal of Money, Credit and Banking, 24, February, 2026. ISSN: 0022-2879

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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:137613

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