Joined at the hip: monetary and fiscal policy in a liquidity-dependent world

Summary

Focus

In a low interest rate environment, financing government operations by issuing bonds is very similar to financing them by issuing bank reserves, ie money. But there remains one key difference: the way their prices are set. The price of money is the inverse of the price level. If prices are sticky, so is the price of money in terms of goods. By contrast, the price of bonds in terms of goods is free to jump all over the place. This difference matters a great deal for a number of monetary and fiscal policy issues.

Contribution

We explore these issues in a bare-bones, conventional model. We assume a liquidity-in-advance constraint, so that households must have sufficient transactional liquidity (money and bonds) in their pockets in order to consume. The monetary policy regime targets the quantity of money, ie central bank reserves, and the interest rate on them, while the interest rate on the bond adjusts to clear markets. In this setting, changes in fiscal policy affect bond prices and, in turn, available liquidity, impacting aggregate demand and output.

Findings

Unanticipated fiscal expansions financed by debt issuance are neutral when permanent, but they are expansionary when transitory. In the former case, the price of bonds drops sufficiently so that total liquidity is unchanged. In the latter, bond prices fall by less than the increase in nominal supply, increasing liquidity, aggregate demand and output. Anticipated fiscal expansions, on the other hand, are recessionary. Bond prices fall faster than their supply, causing the value of government bonds outstanding to decline. The resulting liquidity squeeze causes a drop in aggregate demand and therefore output. To avoid these effects, monetary policy must stabilise bond prices by reducing the interest rate on money and expanding its supply. We conclude that in a liquidity-dependent world, fiscal and monetary policies are joined at the hip.

Abstract

We study the effects of monetary and fiscal policies when both money and government bonds provide liquidity services. Because money is the unit of account, the price of money is the inverse of the price level. If prices are sticky, so is the price of money in terms of goods, and this is one important reason why money is liquid and attractive. By contrast, the price of government bonds is free to jump and often does, especially in response to news about changes in fiscal policy and the supply of bonds. Those movements in government bond prices affect available liquidity, and that matters for aggregate demand, inflation and output. Under these conditions, bond-financed fiscal expansions can be contractionary, causing deflation and a temporary recession. To avoid those effects, changes in bond supply must be matched by changes in money supply and in the interest rate on money. We conclude that in a liquiditydependent world, fiscal and monetary policies are joined at the hip.

Keywords: Monetary policy, fiscal policy, monetary-fiscal interaction.

JEL classification: E52, E62, E63.