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Fiscal Policy in a Tractable Liquidity-Constrained Economy

  • Challe, E.
  • Ragot, X.

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.

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Paper provided by Banque de France in its series Working papers with number 297.

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Length: 61 pages
Date of creation: 2010
Date of revision:
Handle: RePEc:bfr:banfra:297
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  1. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  2. Ricardo J. Caballero & Emmanuel Farhi & Pierre-Olivier Gourinchas, 2006. "An Equilibrium Model of Global Imbalances and Low Interest Rates," 2006 Meeting Papers 894, Society for Economic Dynamics.
  3. Woodford, Michael, 1990. "Public Debt as Private Liquidity," American Economic Review, American Economic Association, vol. 80(2), pages 382-88, May.
  4. Angeletos, George-Marios & Panousi, Vasia, 2009. "Revisiting the supply side effects of government spending," Journal of Monetary Economics, Elsevier, vol. 56(2), pages 137-153, March.
  5. Scheinkman, Jose A & Weiss, Laurence, 1986. "Borrowing Constraints and Aggregate Economic Activity," Econometrica, Econometric Society, vol. 54(1), pages 23-45, January.
  6. Huggett, Mark, 1997. "The one-sector growth model with idiosyncratic shocks: Steady states and dynamics," Journal of Monetary Economics, Elsevier, vol. 39(3), pages 385-403, August.
  7. Roberto Perotti, 2007. "In Search of the Transmission Mechanism of Fiscal Policy," NBER Working Papers 13143, National Bureau of Economic Research, Inc.
  8. Per Krusell & Anthony A. Smith, Jr., . "Income and Wealth Heterogeneity in the Macroeconomy," GSIA Working Papers 1997-37, Carnegie Mellon University, Tepper School of Business.
  9. Heathcote, Jonathan, 2001. "Fiscal Policy with Heterogeneous Agents and Incomplete Markets," Working Papers 01-03, Duke University, Department of Economics.
  10. Holmstrom, B & Tirole, J, 1996. "Private and Public Supply of Liquidity," Working papers 96-21, Massachusetts Institute of Technology (MIT), Department of Economics.
  11. King, R.G. & Baxter, M., 1990. "Fiscal Policy In General Equilibrium," RCER Working Papers 244, University of Rochester - Center for Economic Research (RCER).
  12. Krusell, Per & Smith, Anthony A., 1997. "Income And Wealth Heterogeneity, Portfolio Choice, And Equilibrium Asset Returns," Macroeconomic Dynamics, Cambridge University Press, vol. 1(02), pages 387-422, June.
  13. S. Rao Aiyagari, 1994. "Uninsured Idiosyncratic Risk and Aggregate Saving," The Quarterly Journal of Economics, Oxford University Press, vol. 109(3), pages 659-684.
  14. Bewley, Truman, 1983. "A Difficulty with the Optimum Quantity of Money," Econometrica, Econometric Society, vol. 51(5), pages 1485-504, September.
  15. S. Rao Aiyagari & Ellen R. McGrattan, 1997. "The optimum quantity of debt," Staff Report 203, Federal Reserve Bank of Minneapolis.
  16. Kehoe, Timothy J & Levine, David K, 2001. "Liquidity Constrained Markets versus Debt Constrained Markets," Econometrica, Econometric Society, vol. 69(3), pages 575-98, May.
  17. 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.
  18. Andolfatto, David, 1996. "Business Cycles and Labor-Market Search," American Economic Review, American Economic Association, vol. 86(1), pages 112-32, March.
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