Public spending shock in a liquidity constrained economy
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.
Domains
Economics and Finance
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