Joined at the Hip: Monetary and Fiscal Policy in a Liquidity-Dependent World

Calvo and Velasco study an economy where both money and government bonds provide liquidity services, and they show that this shared role implies bond-financed fiscal expansions can be neutral or contractionary — not merely less effective than hoped. The mechanism turns on a fundamental asymmetry: the price of money in terms of goods is pinned down by sticky prices, whereas the price of long-term bonds is free to jump immediately in response to expected changes in bond supply. When the government announces a future bond-financed transfer to households, bond prices fall right away, compressing total liquidity before a single new bond is actually issued; the liquidity-in-advance constraint then forces aggregate demand and output down, producing a recession that precedes and is qualitatively separable from any subsequent boom. The paper maps four distinct timing cases — unanticipated permanent, anticipated permanent, unanticipated transitory flow, and unanticipated temporary stock — and shows each has a different (and sometimes opposite) short-run sign for output. To prevent these contractionary liquidity effects, the central bank must cut the interest rate on money and expand the money supply in ways that are precisely coordinated with the timing of the bond helicopter drop; in this sense fiscal and monetary authorities are, the authors conclude, joined at the hip. The paper also distinguishes this result from standard fiscal-dominance stories: the monetary authority is not compelled to finance the deficit but to stabilize bond prices in order to protect aggregate demand.

Staggered prices in a utility-maximizing framework

This 1983 Journal of Monetary Economics paper by Guillermo Calvo builds a model of staggered price-setting that is more analytically tractable than the earlier discrete-contract-length models of Phelps (1978) and Taylor (1979, 1980), while grounding the demand side in fully optimizing, infinitely-lived Sidrauski-Brock households. Each firm can revise its price only when a random signal arrives, with the probability that a firm has not yet received a signal after h periods falling exponentially at a constant hazard rate; because signals arrive independently across a continuum of firms, at any instant the economy contains a smooth, non-degenerate distribution of outstanding price vintages, so the aggregate (log) price level becomes a predetermined variable that cannot jump, even though individual firms set prices under perfect foresight over the entire future path of the average price and excess demand. Calvo shows the resulting dynamics can be characterized with largely graphical, phase-diagram techniques, and derives the notable implication that it is the rate of change of inflation, not the level of inflation itself, that is a decreasing function of excess demand – a higher-order inverse Phillips relationship – even though the more familiar positive association between the inflation level and excess demand can still emerge along the equilibrium path. On the household side, families maximize a discounted stream of utility from consumption and real money balances subject to a flow budget constraint, and Calvo introduces a “Price Regulating Mechanism” – a stylized tax-and-subsidy scheme ensuring every consumer effectively pays the same average price – to sidestep the problem of how demand is allocated across differently priced firms. Using this framework, he shows that a one-time unanticipated increase in the money supply can move the economy from excess supply to full employment and, chosen optimally, can attain the first-best outcome; that this monetary policy is welfare-superior to an equivalent fiscal expansion through government spending, because the latter permanently lowers steady-state private consumption; and that pegging the nominal interest rate at a fixed level produces a continuum of equilibrium inflation paths, demonstrating that the indeterminacy problem identified by Sargent and Wallace (1975) under interest-rate pegs is not an artifact of assuming fully flexible prices.

Guillermo A. Calvo | Macro Paper Warehouse

Joined at the Hip: Monetary and Fiscal Policy in a Liquidity-Dependent World

Staggered prices in a utility-maximizing framework