A Macroeconomic Model with Bond Liquidity

Abstract

This paper considers a two-country macro model where private bond can serve as financial liquidity. With incomplete markets, higher bond liquidity leads to higher growth from more efficient financing of investment opportunities, but also generates higher instability by increasing equilibrium leverage and worsening the undercapitalized country’s terms of trade. Numerical experiments, based on a parameterized version of the model, show that welfare cost from instability can outweigh gains from higher growth. In particular, bond liquidity reduces welfare in economies with low fundamental volatilities and low credit market frictions, as leverage and hence stationary distribution in such environments are more sensitive to interest rate changes. In terms of macroprudential regulations, bond liquidity can significantly relax the optimal tightness of leverage constraints, while also moderately increase the optimal tax on credit. Lastly, this paper distinguishes between public and private liquidity, and explores the model’s fiscal policy implications.

Keywords: Bond Liquidity, International Capital Flows, Macroprudential Regulation, Fiscal Policy

JEL Classification: E44, F36, F38, F42, G15, G23