Optimal Policy with Liquidity Frictions

41 Pages Posted: 10 Feb 2017

See all articles by Wei Cui

Wei Cui

University College London

Diogo Guillen

Gavea Investments

Date Written: August 7, 2014

Abstract

The recent financial crisis has shown that liquidity fluctuations in asset markets can have a large impact on the real economy. Many central banks started unconventional monetary policies in 2008, but we still have little understanding of optimal monetary and fiscal policies in such an environment. To fill this gap, we develop a tractable optimal policy plan for a heterogeneous agent model with liquidity frictions. The model features incomplete markets for investment opportunities and resaleability frictions of privately issued assets. In steady state, taxation may not be needed and the optimal policy can achieve the first-best allocation by a variant of "Friedman Rule'': buying some private claims by issuing liquid government bonds and use the return to pay bond holders. The calibration shows that the optimal policy plan can raise permanent output by 1.7% compared to a constant supply of government bonds. In response to adverse liquidity shocks, the optimal policy prescribes both taxation and unconventional monetary policies to prevent a flight to liquidity. Taxation is important in the wealth redistribution to avoid devaluing government bonds.

Keywords: Liquidity Frictions, Optimal Monetary and Fiscal Policy, Redistribution and Efficiency

JEL Classification: E20, G10, E40, E50, E60

Suggested Citation

Cui, Wei and Guillen, Diogo, Optimal Policy with Liquidity Frictions (August 7, 2014). Available at SSRN: https://ssrn.com/abstract=2477334 or http://dx.doi.org/10.2139/ssrn.2477334

Wei Cui (Contact Author)

University College London ( email )

Gower Street
London, WC1E 6BT
United Kingdom

Diogo Guillen

Gavea Investments ( email )

1100 Avenue, 7th floor
Ataulfo de Paiva, Leblon
Rio De Janeiro, 22440-035
Brazil

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