Monetary-fiscal Interactions with Liquidity Frictions
I develop a novel and tractable macro model with endogenous asset liquidity to understand monetary-fiscal interactions with liquidity frictions. The model features competitive search markets for privately-issued assets and endogenous asset liquidity. The asset liquidity determines entrepreneurs’ financing constraints and the ability to carry out idiosyncratic investment. Government bonds, on the hand, are fully liquid and used for precautionary savings. A higher level of real government debt enhances the liquidity of entrepreneurs’ portfolios and raises private investment. However, the issuance of debt also raises the real interest rate and the cost of government financing. In steady state, an optimal supply of government debt emerges. I also show that a proper mix of monetary and fiscal policies can avoid a deep financial recession.