The Side Effects of Safe Asset Creation
58 Pages Posted: 3 Mar 2020
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The Side Effects of Safe Asset Creation
Date Written: February 2020
Abstract
We present an incomplete markets model to understand the costs and benefits of increasing government debt when an increased demand for safety pushes the natural rate of interest below zero. A higher demand for safety widens spreads, causing the ZLB to bind and increasing unemployment. Higher government debt satiates the demand for safe assets, raising the natural rate, and restoring full employment. This entails permanently lower investment which reduces welfare, since our economy is dynamically efficient even when the natural rate is negative. Despite this, increasing debt is optimal if alternative instruments are unavailable. Alternative policies which permit negative real interest rates - higher inflation targets, negative nominal rates - achieve full employment without reducing investment.
Keywords: Crowding out, liquidity traps, negative natural rate, Risk premium, safe assets
JEL Classification: E3, E4, E5, G1, H6
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