Monetary and fiscal policies interact with each other and one has to take the lead. In this paper, Saroj Dhital, Pedro Gomis-Porqueras, and Joe Haslag study two sets of interactions. One in which the Federal Reserve sets its policy and the U.S. Treasury follows and one in which the roles are reversed. The contribution of this paper is to study both sets of interactions in a world in which banks offer some partial insurance to depositors, provide liquidity for transactions that require money, and also can abscond with part of the deposits. With the ability abscond, banks must provide collateral. Interestingly, government bonds provide good collateral (short-term bonds) and less-good collateral (long-term bonds). The implication is that debt management practices spillover in terms of the effects of monetary policy. The model is also rich enough to study how people pay for things—their liquidity needs—affect the distribution of consumption.
Formal Abstract: In this paper, we study the interactions between fiscal and monetary policy in a frictional economy where fiat money, bank deposits and short and long-term nominal government bonds coexist. Since agents face information frictions and bankers have limited commitment, bank deposits need to be collateralized with nominal public debt. These bank deposits can only be used as payment instruments in some states of the world, while fiat money is always accepted. Within this frictional environment, we study monetary and fiscal policy interactions under different policy stances. When the monetary authority follows an active policy regime, a unique stationary equilibria exists regardless of how the supply of the various nominal government bonds is specified. Under this policy regime, we also find that consumption inequality increases when the central bank pursues an expansionary monetary policy. In contrast, when the fiscal authority pursues active policies, real indeterminacies can exist. However, when the fiscal authority issues sufficiently few long (or short) term bonds, a unique steady state exists. We also identify cases where an expansionary fiscal policy lead to a decline in consumption inequality between money transactions and deposit-backed transactions. Finally, regardless of the policy regime chosen by the government, financial innovations alter the relative demand for public debt and do not always lead to an increase in welfare.