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Public spending shocks in a liquidity-constrained economy

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  • Edouard Challe

    ()
    (DRM - Dauphine Recherches en Management - CNRS : UMR7088 - Université Paris IX - Paris Dauphine)

  • Xavier Ragot

    (EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris, PSE - Paris-Jourdan Sciences Economiques - CNRS : UMR8545 - École des Hautes Études en Sciences Sociales (EHESS) - École des Ponts ParisTech (ENPC) - École normale supérieure [ENS] - Paris)

Abstract

This paper analyses the effect of transitory increases in government spending when public debt is used as liquidity by the private sector. Aggregate shocks are introduced into an incomplete-market economy where heterogenous, infinitely-lived households 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 effect that are produced by the shock

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Paper provided by HAL in its series PSE Working Papers with number halshs-00587686.

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Date of creation: Dec 2007
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Handle: RePEc:hal:psewpa:halshs-00587686

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Keywords: borrowing constraints ; public debt ; fiscal policy shocks;

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  1. Jonathan Heathcote, 2003. "Fiscal Policy with Heterogeneous Agents and Incomplete Markets," Working Papers, Georgetown University, Department of Economics gueconwpa~03-03-23, Georgetown University, Department of Economics.
  2. Kehoe, Timothy J & Levine, David K, 2001. "Liquidity Constrained Markets versus Debt Constrained Markets," Econometrica, Econometric Society, Econometric Society, vol. 69(3), pages 575-98, May.
  3. Galí, Jordi & Perotti, Roberto, 2003. "Fiscal Policy and Monetary Integration in Europe," CEPR Discussion Papers, C.E.P.R. Discussion Papers 3933, C.E.P.R. Discussion Papers.
  4. Vasia Panousi & George-Marios Angeletos, 2007. "Revisiting the Supply-Side Effects of Government Spending Under Incomplete Markets," 2007 Meeting Papers, Society for Economic Dynamics 545, Society for Economic Dynamics.
  5. Burnside, Craig & Eichenbaum, Martin & Fisher, Jonas D. M., 2004. "Fiscal shocks and their consequences," Journal of Economic Theory, Elsevier, Elsevier, vol. 115(1), pages 89-117, March.
  6. Aiyagari, S. Rao & McGrattan, Ellen R., 1998. "The optimum quantity of debt," Journal of Monetary Economics, Elsevier, Elsevier, vol. 42(3), pages 447-469, October.
  7. Ravn, Morten O. & Schmitt-Grohé, Stephanie & Uribe, Martín, 2004. "Deep Habits," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4269, C.E.P.R. Discussion Papers.
  8. King, R.G. & Baxter, M., 1990. "Fiscal Policy In General Equilibrium," RCER Working Papers 244, University of Rochester - Center for Economic Research (RCER).
  9. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, American Economic Association, vol. 80(2), pages 382-88, May.
  10. Roberto Perotti, 2007. "In Search of the Transmission Mechanism of Fiscal Policy," NBER Working Papers 13143, National Bureau of Economic Research, Inc.
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