Monetary-fiscal interaction and the liquidity of government debt

Cristiano Cantore and Edoardo Leonardi

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

Abstract: How does the monetary and fiscal policy mix alter households’ saving incentives? To answer these questions, we build a heterogenous agents New Keynesian model where three different types of agents can save in assets with different liquidity profiles to insure against idiosyncratic risk. Policy mixes affect saving incentives differently according to their effect on the liquidity premium- the return difference between less liquid assets and public debt. We derive an intuitive analytical expression linking the liquidity premium with consumption differentials amongst different types of agents. This underscores the presence of a transmission mechanism through which the interaction of monetary and fiscal policy shapes economic stability via its effect on the portfolio choice of private agents. We call it the self-insurance demand channel, which moves the liquidity premium in the opposite direction to the standard policy-driven supply channel. Our analysis thus reveals the presence of two competing forces driving the liquidity premium. We show that the relative strength of the two is tightly linked to the policy mix in place and the type of business cycle shock hitting the economy. This implies that to stabilize the economy, monetary policy should consider the impact of the self-insurance on the liquidity premium.

Keywords: monetary–fiscal interaction; HANK; government debt; liquidity (search for similar items in EconPapers)
JEL-codes: E12 E52 E58 E62 E63 (search for similar items in EconPapers)
Pages: 21 pages
Date: 2025-04-30
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Published in European Economic Review, 30, April, 2025, 173. ISSN: 0014-2921

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