Joined at the Hip: Monetary and Fiscal Policy in a Liquidity-Dependent World

Guillermo Calvo and Andrés Velasco

No 29865, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: E12 E4 E42 E44 E52 E58 E62 (search for similar items in EconPapers)
Date: 2022-03
New Economics Papers: this item is included in nep-ban, nep-mac and nep-mon
Note: IFM ME
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Citations: View citations in EconPapers (3)

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