Bond Premium Cyclicality and Liquidity Traps

Nicolas Caramp and Sanjay Singh

The Review of Economic Studies, 2023, vol. 90, issue 6, 2822-2879

Abstract: Safe asset shortages can expose an economy to liquidity traps. The nature of these traps is determined by the cyclicality of the bond premium. A counter-cyclical bond premium opens the possibility of expectations-driven liquidity traps in which small issuances of government debt crowd out private debt and reduce output. In contrast, when the bond premium is pro-cyclical and the economy is in a liquidity trap, government debt is expansionary. In the data, we find evidence of a counter-cyclical bond premium. Large interventions can prevent the emergence of self-fulfilling traps, but they require sufficient fiscal capacity. In a quantitative model calibrated to the Great Recession, a promise to increase the government debt-to-GDP ratio by 20 percentage points precludes the possibility of self-fulfilling traps.

Keywords: Bond premium; Safe assets; Liquidity trap (search for similar items in EconPapers)
Date: 2023
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