Fiscal Requirements for Dynamic and Real Determinacies in Economies with Private Provision of Liquidity: A Monetarist Assessment

• Published date: 01 February 2020
• Author: PEDRO GOMIS‐PORQUERAS
• Date: 01 February 2020
• DOI: http://doi.org/10.1111/jmcb.12587

DOI: 10.1111/jmcb.12587

PEDRO GOMIS-PORQUERAS

Fiscal Requirements for Dynamic and Real

Determinacies in Economies with Private Provision

of Liquidity: A Monetarist Assessment

Westudy the impact of f‌iscal policies on the inherent links between inf‌lation,

unemployment, and asset prices in an environment where f‌irms provide

liquidity and the central bank follows a constant money growth rate rule.

Firms, other than hiring workers, also supply private assets that are not

only useful as a store of value but also as collateral. When f‌irms are not

taxed and public debt is scarce, the economy is non-Ricardian so that real

indeterminacies can be observed. Moreover, labor market characteristics

do not affect the demand for government liabilities. However,when agents

face public and private asset scarcity, labor market conditions then impact

asset prices and inf‌lation. We further show that irrespective of the type of

asset scarcity agents face, when f‌irms are taxed non-ad valorem, not only

the level of tax revenuesbut also its composition matter for real allocations.

Moreover,we show that labor market conditions directly affect the dynamics

of all government liabilities and inf‌lation.

JEL codes:D82, D83, E40, E50

Keywords:decentralized f‌inancial markets, unemployment, liquidity,

f‌iscal rules.

AFTER 2008, THE FEDERAL RESERVE System followed more

closely the developments in f‌inancial and labor markets. At the time, the Federal

Open Market Committee was concerned with the effect of increasing unemploy-

ment rates could have on f‌inancial markets and their potential effects on prolonged

This paper was previously circulated under the title “Fiscal Requirements for Price Stability in

Economies with Private Provision of Liquidity and Unemployment.” I would like to thank the editor

and anonymous referees for their valuable comments and suggestions. I am also grateful to Guillaume

Rocheteau, Randy Wright, Alberto Trejos, Eric Leeper, Todd Walker, Cathy Zhang, and Chris Edmond

for their helpful feedback.

PEDRO GOMIS-PORQUERAS is at Department of Economics, Deakin University (E-mail: peregomis@

gmail.com).

Received February 20, 2018; and accepted in revised form October 19, 2018.

Journal of Money, Credit and Banking, Vol. 52, No. 1 (February 2020)

C

2018 The Ohio State University

230 :MONEY,CREDIT AND BANKING

def‌lationary periods.1In this paper, we explore the channels through which labor and

f‌inancial markets interact and ultimately impact the economy. To do so we consider

an environment with labor and f‌inancial frictions, where agents have access to mul-

tiple assets (both private and public) that are traded in a variety of f‌inancial markets.

Within this frictional environment, we analyze the impact of f‌iscal policies on inf‌la-

tion, public debt, and unemployment dynamics when monetary policy is given by a

constant money growth rate rule.

Firms, other than hiring workers, also supply private assets that are claims to their

future prof‌its. These f‌inancial instruments are not only useful as a store of value but

also as collateral when trading in some frictional markets. Agents in these markets

face limited commitment problems and anonymity. Relative to environments with a

f‌ixed supply of private assets, the channels through which monetary and f‌iscal policy

interact are more intricate. Once the supply of private assets is endogenous and

responds to the economic environment, government policies that affect f‌irms’ prof‌its

have a direct impact on the total assets in the economy as well as unemployment.

Moreover, by affecting the relative prices between private and public assets, f‌iscal

and monetary policies also impact the portfolio of agents. This is the case as f‌irms

link both labor and f‌inancial markets.

To study inf‌lation, unemployment, and public debt dynamics, this paper builds on

Rocheteau and Rodriguez-Lopez (2014). There are three different inf‌initely lived pri-

vate agents: workers, f‌irms, and traders. To generate unemployment, the environment

has a frictional labor market alaMortensen and Pissarides (1994), where matched

workers and f‌irms produce a homogeneous perishable good. Firms also supply pri-

vate assets by issuing claims to their future prof‌its. The demand for both private and

public assets arise from traders alaShi (1995) and Trejos and Wright (1995), which

from now we refer to Shi–Trejos–Wright traders.2These agents can also produce and

consume the homogeneous perishable good. What makes these Shi–Trejos–Wright

traders different from workers is that they also have stochastic trading opportunities

in decentralized frictional f‌inancial markets. In these markets, Shi–Trejos–Wright

agents obtain f‌inancial services that they only value while facing anonymity, limited

commitment, and asset recognizability problems. As a result, in order to trade in these

markets, collateralized loans are required. Finally, these Shi–Trejos–Wright traders

1.The Federal Open Market Committee was providing guidance about the conduct of monetary policy

in relation to the evolution of unemployment. “In setting monetary policy,the Committee seeks to mitigate

deviations of inf‌lation fromits longer-run goal and deviations of employment from the Committee’s assess-

ments of its maximum level. These objectives aregenerally complementary. However,under circumstances

in which the Committee judges that the objectives are not complementary,it follows a balanced approach

in promoting them, taking into account the magnitude of the deviations and the potentially differenttime

horizons over which employment and inf‌lation are projected to returnto levels judged consistent with its

mandate.” Statements from the Federal Open Market Committee, January 2012, 2013, and 2014.

2.These authors emphasize the role of assets (money) as media of exchange. Recently, search and

bargaining frictions havebeen also emphasized by Duff‌ie, Garleanu, and Pedersen (2005) when describing

over the counter (OTC)f‌inancial markets. Trejos and Wright (2016) discuss the similarities and differences

between the monetary economics used by Shi (1995) or Trejos and Wright (1995), with the applications

in f‌inance used by Duff‌ie, Garleanu, and Pedersen (2005). The authors integrate the two approaches and

generate endogenous transaction patterns and belief-based dynamics.

PEDRO GOMIS-PORQUERAS:231

have also access to a frictionless f‌inancial market where they can rebalance their

portfolio.

Since f‌irms employ workers and supply private assets, this environment links

portfolios and unemployment. As a result, private and public asset returns depend

on labor market conditions. In particular, the more asset scarcity is faced by traders,

the larger the impact labor market conditions have on f‌inancial markets. Moreover,

as in Friedman (1956), Tobin (1961), and Brunner and Meltzer (1972) pointed out,

the equilibrium price level is determined by the joint valuation of all assets through

agents’ portfolio decisions. However,in contrast to Tobin (1961), in this environment,

the price level is also affected by the labor market. Moreover, interest rate spreads are

not driven by the risk properties of assets but rather by the collateral needs of agents,

labor market conditions, and f‌iscal policies.

Conventional stabilization policy, which rules out indeterminate equilibria,

suggests that monetary policy controls inf‌lation, while f‌iscal policy stabilizes debt

through an appropriate adjustment in current or future taxation.3To have a better

understanding of the role of liquidity and the economy’s taxing capacity on the nature

of the stabilization policies, we f‌irst analyze an environment where only Shi–Trejos–

Wright traders are taxed. We then also impose non-ad valorem taxes to workers

and f‌irms. When agents face positive nominal interest rates, bonds are scarce and

Shi–Trejos–Wright traders are the only agents that are taxed, the real return on public

debt is affected by both inf‌lation and government debt. These make the total interest

payment on government bonds nonlinear, thus breaking Ricardian equivalence. This

feature allows the possibility for real indeterminacies, which are solely driven by

the collateral needs of traders. This is the case as there are different combinations of

steady state inf‌lation rates and real debt consistent with the same total revenue, thus

allowing potential for self-fulf‌illing beliefs.4Thus, it is not surprising that we f‌ind

drastically different inf‌lation expectationsrelative to frictionless environments.5Thus,

traditional stabilization policies do not always yield locally determinate equilibria.

In contrast, when government liabilities are plentiful, a unique stationary monetary

equilibrium where monetary and f‌iscal policies do not affect the labor market

exists.

When workers, f‌irms, and Shi–Trejos–Wright traders face non-ad valorem taxes,

f‌iscal policies directly affect the f‌irms’ decision to participate in the labor market.

As a result, f‌iscal policy directly impacts the total supply of private assets. This

f‌iscal effect is found irrespective of the degree of asset scarcity that Shi–Trejos–

Wright traders face. Note that when f‌irms expect future taxes to be high, they reduce

3.We refer to Friedman (1968) for more discussion on this point.

4.Similar features are observed in Dom´

ınguez and Gomis-Porqueras (2018), where agents do not face

unemployment and do not have access to real assets.

5.The way monetary and f‌iscal policies interact critically depends on the beliefs about future inf‌lation.

These beliefs are not only inf‌luenced by f‌iscal and monetary policies, as noted by Sargent and Wallace

(1981) and Leeper (1991), but also by f‌inancial frictions, as highlighted by Fern´

andez-Villaverde (2010),

Leeper and Nason (2015), Gomes and Seoane (2015), Dom´

ınguez and Gomis-Porqueras (2018), among

others.