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Fiscal Sustainability when Public Debt is High: The Role of Portfolio Liquidity

Author

Listed:
  • Cristiano Cantore
  • Matteo Gatto
  • Francesco Saverio Gaudio
  • Pascal Meichtry

Abstract

This paper studies how the prevailing level of public debt shapes the transmission of fiscal and monetary policy shocks in a tractable heterogeneous three-agent New Keynesian model. When households rely on the liquidity services of government bonds to self-insure against idiosyncratic risk, higher public indebtedness amplifies the deterioration in debt sustainability after expansionary government spending shocks. In such economies, fiscal expansions weaken precautionary bond demand, requiring the central bank to keep real interest rates higher for longer and thereby raising debt servicing costs and narrowing fiscal space. By contrast, the transmission of monetary expansions is largely invariant to the initial debt level, as such shocks have little effect on the insurance value of government bonds. These results highlight the central role of the liquidity premium and self-insurance motive in linking initial public indebtedness to long-run fiscal sustainability.

Suggested Citation

  • Cristiano Cantore & Matteo Gatto & Francesco Saverio Gaudio & Pascal Meichtry, 2026. "Fiscal Sustainability when Public Debt is High: The Role of Portfolio Liquidity," Working papers 1055, Banque de France.
    • Handle: RePEc:bfr:banfra:1055
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    File URL: https://www.banque-france.fr/system/files/2026-07/Fiscal%20Sustainability%20when%20Public%20Debt%20is%20High%20The%20Role%20of%20Portfolio%20Liquidity.pdf
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    Keywords

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    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • 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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