Interactions of monetary and fiscal policy in a business cycle model with open market operations

Consensus monetary business cycle theory is hardly able to rationalize why fiscal policy is repeatedly found to stimulate private consumption and why monetary policy should care about Ricardian fiscal policy. In this paper we demonstrate that this changes when government bonds provide liquidity services. We develop a simple business cycle, which can be solved analytically, where money is supplied via open market operations. When only government bonds are accepted as a collateral for money and private debt earns a higher interest, real public debt eases households' access to money and Ricardian equivalence does not hold. Interest rate policy is not restricted by requirements for equilibrium determinacy and its effects are consistent with common priors. Shocks are propagated via changes in financial wealth and persistence is altered by the stance of fiscal and monetary policy. overnment expenditures, which are not completely tax financed, can raise private consumption when monetary policy is not too reactive. Similarly, a moderate interest rate policy allows a deficit financed tax cut to stimulate real activity.