When Ramsey Searches for Liquidity

What are the optimal policies in an economy with endogenous liquidity frictions? In this paper, liquidity constraints arise because of costly search-and-matching of non-government issued assets. Government bonds, on the other hand, are fully liquid. I show how to characterize the optimal level of government debt, capital tax, and the initial price level, given an initial level of capital stock. There are two main lessons learned from policy making in such a liquidity constrained framework. Taxes on capital converges to a level that balances the trade-off between the efficiency of financing government expenditures and consumption inequality (due to search frictions). A long-run optimal debt-to-GDP ratio can be independent of the initial level of capital stock, when the economy exhibits a balanced growth path. A calibrated version of the model shows that it should be around 66%. This paper suggests that countries which have accumulated a large amount of debt since the recent financial crisis should not permanently roll over their debt.