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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. Morten Ravn & Stephanie Schmitt-Grohe & Martin Uribe, 2004. "Deep Habits," NBER Working Papers 10261, National Bureau of Economic Research, Inc.
  2. Jordi Gali & Roberto Perotti, 2003. "Fiscal Policy and Monetary Integration in Europe," NBER Working Papers 9773, National Bureau of Economic Research, Inc.
  3. Kehoe, Timothy J & Levine, David K, 2001. "Liquidity Constrained Markets versus Debt Constrained Markets," Econometrica, Econometric Society, vol. 69(3), pages 575-98, May.
  4. S. Rao Aiyagari & Ellen R. McGrattan, 1997. "The optimum quantity of debt," Staff Report 203, Federal Reserve Bank of Minneapolis.
  5. Roberto Perotti, 2007. "In Search of the Transmission Mechanism of Fiscal Policy," NBER Working Papers 13143, National Bureau of Economic Research, Inc.
  6. Heathcote, Jonathan, 2001. "Fiscal Policy with Heterogeneous Agents and Incomplete Markets," Working Papers 01-03, Duke University, Department of Economics.
  7. King, R.G. & Baxter, M., 1990. "Fiscal Policy In General Equilibrium," RCER Working Papers 244, University of Rochester - Center for Economic Research (RCER).
  8. Burnside, Craig & Eichenbaum, Martin & Fisher, Jonas D. M., 2004. "Fiscal shocks and their consequences," Journal of Economic Theory, Elsevier, vol. 115(1), pages 89-117, March.
  9. George-Marios Angeletos & Vasia Panousi, 2007. "Revisiting the Supply-Side Effects of Government Spending Under Incomplete Markets," NBER Working Papers 13136, National Bureau of Economic Research, Inc.
  10. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-88, May.
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