Fiscal Sustainability when Public Debt is High: The Role of Portfolio Liquidity

Cristiano Cantore, Matteo Gatto, Francesco Saverio Gaudio and Pascal Meichtry

Working papers from Banque de France

Abstract: This paper studies how the prevailing level of public debt shapes the transmission of fiscal and monetary policy shocks in a tractable heterogeneous three-agent New Keynesian model. When households rely on the liquidity services of government bonds to self-insure against idiosyncratic risk, higher public indebtedness amplifies the deterioration in debt sustainability after expansionary government spending shocks. In such economies, fiscal expansions weaken precautionary bond demand, requiring the central bank to keep real interest rates higher for longer and thereby raising debt servicing costs and narrowing fiscal space. By contrast, the transmission of monetary expansions is largely invariant to the initial debt level, as such shocks have little effect on the insurance value of government bonds. These results highlight the central role of the liquidity premium and self-insurance motive in linking initial public indebtedness to long-run fiscal sustainability.

Keywords: Monetary–Fiscal Interactions; Heterogeneity; Liquidity; Self-Insurance; Government Debt; Debt Sustainability (search for similar items in EconPapers)
JEL-codes: E21 E52 E58 E62 E63 (search for similar items in EconPapers)
Pages: 37 pages
Date: 2026
New Economics Papers: this item is included in nep-dge
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Persistent link: https://EconPapers.repec.org/RePEc:bfr:banfra:1055

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