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Public spending shock in a liquidity constrained economy

Author

Listed:
  • Edouard Challe
  • Xavier Ragot

    (Département d'économie)

Abstract

This paper analyses the e§ects of transitory increases in government spending when public debt is used as liquidity by the private sector. Aggregate shocks are introduced into a áexible-price, incomplete-market economy where heterogenous, inÖnitely-lived households face occasionally binding borrowing constraints and store wealth to smooth out idiosyncratic income áuctuations. Debt-Önanced 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 Örms, 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 e§ects that arise following the shock.

Suggested Citation

  • Edouard Challe & Xavier Ragot, 2008. "Public spending shock in a liquidity constrained economy," Sciences Po publications 2007-48, Sciences Po.
  • Handle: RePEc:spo:wpmain:info:hdl:2441/22sqasvlo496gr515iea84b26f
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    More about this item

    Keywords

    Borrowing constraints; Public debt; Fiscal policy shocks;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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