Monetary-Fiscal Interaction and the Liquidity of Government Debt

TL;DR

This paper develops a heterogenous agents New Keynesian model to analyze how monetary and fiscal policy interactions influence household saving incentives through liquidity premiums, revealing a self-insurance channel affecting economic stability.

Contribution

It introduces an analytical framework linking liquidity premiums to consumption differences, highlighting a new self-insurance demand channel in policy interactions.

Findings

Liquidity premiums are affected by policy mix and economic shocks.

Two competing forces influence the liquidity premium: policy-driven supply and self-insurance demand.

Monetary policy should consider self-insurance effects to stabilize the economy.

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.