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Public spending shocks in a liquidity-constrained economy

Author

Listed:
  • Edouard Challe

    () (DRM - Dauphine Recherches en Management - Université Paris-Dauphine - CNRS - Centre National de la Recherche Scientifique)

  • Xavier Ragot

    (PSE - Paris School of Economics, PJSE - Paris-Jourdan Sciences Economiques - ENS Paris - École normale supérieure - Paris - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique)

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

Suggested Citation

  • Edouard Challe & Xavier Ragot, 2007. "Public spending shocks in a liquidity-constrained economy," PSE Working Papers halshs-00587686, HAL.
  • Handle: RePEc:hal:psewpa:halshs-00587686 Note: View the original document on HAL open archive server: https://halshs.archives-ouvertes.fr/halshs-00587686
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    References listed on IDEAS

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    1. Vasia Panousi & George-Marios Angeletos, 2007. "Revisiting the Supply-Side Effects of Government Spending Under Incomplete Markets," 2007 Meeting Papers 545, Society for Economic Dynamics.
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