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Monetary-fiscal interaction and the liquidity of government debt

Author

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  • Cantore, Cristiano
  • Leonardi, Edoardo

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.

Suggested Citation

  • Cantore, Cristiano & Leonardi, Edoardo, 2025. "Monetary-fiscal interaction and the liquidity of government debt," LSE Research Online Documents on Economics 127221, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:127221
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    More about this item

    Keywords

    monetary–fiscal interaction; HANK; government debt; liquidity;
    All these keywords.

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy

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