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Fiscal Policy in a Tractable Liquidity-Constrained Economy

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  • Challe, E.
  • Ragot, X.

Abstract

In this paper, we analyse the effects of transitory fiscal expansions when public debt is used as liquidity by the private sector. Aggregate shocks are introduced into a tractable flexible-price, incomplete-market economy where heterogenous, infinitely-lived agents face occasionally binding borrowing constraints and store wealth to smooth out idiosyncratic income fluctuations. Debt-financed increases in public spending facilitate self insurance by bond holders and may crowd in private consumption. The implied higher stock of liquidity also loosens the borrowing constraints faced by firms, thereby raising labour demand and possibly the real wage. Whether private consumption and wages actually rise or fall ultimately depends on the relative strengths of the liquidity and wealth effects that arise following the shock. The expansionary effects of tax cuts are also discussed. Classification-JEL: E21; E62.

Suggested Citation

  • Challe, E. & Ragot, X., 2010. "Fiscal Policy in a Tractable Liquidity-Constrained Economy," Working papers 297, Banque de France.
    • Handle: RePEc:bfr:banfra:297
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    More about this item

    Keywords

    Borrowing constraints; Public Debt; Fiscal Policy Shocks.;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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