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

Layer 1 — What this paper finds and why it matters

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.

Summary based on working paper (LSE Research Online accepted version, December 2025). AI-assisted, human review pending. See the linked original for authoritative claims.

Layer 2 — In depth

Q1. What is the central question and how does the paper differ from the standard New Keynesian framework?

The central question is whether bond-financed government transfers raise, lower, or leave unchanged aggregate demand and output when bonds provide liquidity services. Standard Keynesian and New Keynesian treatments focus on whether expansionary fiscal policy crowds out private investment through higher interest rates, or amplifies demand when the zero lower bound binds. Calvo and Velasco instead focus on the liquidity channel: because long-term bond prices are free to jump on news about future bond supply, increases in expected bond issuance can immediately reduce the market value of outstanding bonds, compressing total liquidity in private portfolios and thereby reducing consumption and output even before any new bond is issued. They call this a “non-standard” result and note that, by contrast, the price of money is insulated from such anticipatory jumps by sticky goods prices.

Q2. What is the model structure?

The paper uses a bare-bones, continuous-time, closed-economy model with a single infinitely lived household, one consumption good, and two assets in positive net supply: money (equated with central-bank reserves) and a long-term government bond (a perpetuity paying a coupon). The key friction is a liquidity-in-advance constraint — households must hold sufficient liquidity (a weighted combination of real money balances and the real market value of bonds) to consume. The supply side is a standard Calvo (1983) Phillips curve. Policy instruments are the nominal interest rate on money, the nominal money supply, the nominal bond supply, and the bond coupon; the price of long-term bonds is endogenous. Commercial banks are abstracted away: money is effectively a CBDC. The paper notes that all main results also go through under a money-in-the-utility-function specification, provided the elasticity of substitution between consumption and liquidity is sufficiently low.

Q3. What does “liquidity” mean in the paper’s own sense, and why does the bond price matter for it?

Liquidity is defined as a CES-weighted sum of real money holdings and the real market value of bond holdings, where the market value of bonds equals the bond price times the real quantity outstanding. Because the bond price is free to jump, the market value of bonds (and therefore total liquidity) can change instantaneously in response to news, even when neither the nominal money stock nor the nominal bond stock has yet changed. Money does not share this vulnerability: its “price” in terms of goods is fixed in the short run by nominal price stickiness. This asymmetry — sticky price of money, flexible price of bonds — is the paper’s central mechanism. The authors attribute the stickiness insight to Keynes’s General Theory (the “price theory of money” as labelled by Calvo 2012).

Q4. What happens when the bond supply rises unexpectedly and permanently?

An unanticipated and permanent step increase in the nominal (and, on impact, real) supply of long-term bonds is neutral: consumption and output are unchanged. Bond prices fall immediately so that the total market value of bonds outstanding — and therefore total liquidity — is the same as before. The analogy drawn is to an unanticipated permanent increase in the money supply under fully flexible prices, which also has no real effects. The coupon must rise proportionally so that the return on bonds remains at its steady-state level. The paper notes that neutrality may not hold if bond holdings are distributed non-uniformly (e.g., concentrated in financial intermediaries that use bonds as repo collateral), because the drop in bond prices could trigger runs on those institutions.

Q5. What happens when a permanent bond-supply increase is anticipated in advance?

An anticipated and permanent future step increase in nominal bond supply causes a recession during the announcement-to-implementation interval, before any new bond has been issued. Because arbitrage prevents an anticipated capital loss on bonds, the bond price cannot jump down at the implementation date T. Instead it must fall gradually starting at announcement date 0, reaching its new (lower) steady-state level exactly at T. This declining bond price reduces the market value of bonds and thereby compresses total liquidity throughout the interval [0, T), generating deflation and a negative output gap over that entire period. A naïve observer who notes an output boom just as the government begins to issue bonds at T would incorrectly conclude the policy is expansionary, when in fact the boom is the recovery from the pre-implementation recession.

Q6. What happens when the fiscal authority issues bonds at a constant rate for a finite period (transitory flow)?

An unanticipated, transitory, constant-rate bond issuance over an interval [0, T) also has a recessionary impact on impact and during the issuance period. Bond prices fall faster than the nominal bond stock accumulates, so the total market value of bonds declines and liquidity is compressed. The Calvo-Phillips equation evaluated with negative and rising inflation implies a negative output gap throughout the early part of the episode. A boom follows after bond issuance ends — not because “confidence is restored” or fiscal sustainability has improved, but because the boom is mechanically part of the same liquidity-adjustment cycle as the earlier recession.

Q7. What happens under an unanticipated but temporary step increase in the bond stock?

An unanticipated but temporary step increase in bond supply — one that will be reversed at a known future date T — is expansionary on impact. Because the price of bonds cannot be anticipated to jump at T, the bond price must rise from its impact level back to the initial steady state by T. On impact, the bond price falls but by less than the increase in nominal bond supply, so the market value of bonds rises and total liquidity increases, pushing aggregate demand and output above their natural rates. The initial boom is thus followed by a recession around the time bond supply is cut back, which the authors note could generate political pressure to extend the “expansionary” fiscal policy.

Q8. What is the common mechanism linking the contractionary cases?

In both contractionary cases (anticipated permanent and unanticipated transitory flow), the bond price falls more rapidly than the bond stock rises, so the total market value of bonds declines, compressing liquidity. From the model’s liquidity identity (equation 18 in the paper), total liquidity depends on real money balances (fixed on impact) plus a weight on the relative position of bonds to money. When that relative position (captured by the variable s_t in the model) falls, total liquidity falls. The liquidity-in-advance constraint then directly constrains consumption and output downward. Deflation is the only endogenous mechanism to rebuild real liquidity, but it works gradually and involves a protracted recession.

Q9. What monetary policy does the paper prescribe to neutralize the contractionary effects?

To avoid the contractionary liquidity effects of anticipated bond helicopter drops, the central bank must cut the interest rate on money and expand the money supply in a manner whose precise time profile depends on the timing of the fiscal shock. For an anticipated permanent bond-supply increase, the required monetary response involves gradually expanding the nominal money supply between announcement and implementation, followed by a discrete step decrease in nominal (and real) money at exactly the moment bond supply jumps up. This coordinated monetary expansion offsets the bond-price-driven compression of liquidity. The paper confirms this formally in Section IV (not fully extracted in the source text), with the conclusion that avoiding unwanted contractionary effects requires coupling fiscal bond issuance with specific, coordinated monetary actions.

Q10. How does the paper relate to fiscal dominance — and how does it differ?

The paper identifies a novel form of fiscal dominance in which monetary policy is compelled not to monetize the fiscal deficit but to stabilize government bond prices in order to protect aggregate demand and inflation. Traditional fiscal dominance (common in emerging markets) forces the central bank to print money to finance the deficit. Here, the mechanism is different: expected bond issuance drives down bond prices and compresses liquidity, so the central bank must intervene in bond markets — effectively buying newly issued bonds — to prevent deflationary recessions. An outside observer could mistake this for traditional monetization. The paper frames the Federal Reserve’s $1 trillion Treasury purchase program from mid-March 2020 onward as consistent with this bond-price-stabilization logic, citing Vissing-Jorgensen (2021) on the causal role of Fed purchases in driving down yields through acute liquidity provision.

Q11. What is the scope of the non-standard results?

The non-standard (neutral or contractionary) results apply specifically to bond-financed increases in government transfers to the private sector; money-financed fiscal expansion and bond-financed government consumption changes are not the focus and do not share these properties in the model. The authors explicitly note this caveat. However, they argue the exercise is policy-relevant because much of the fiscal response to both the 2008 Global Financial Crisis and the Covid-19 crisis took the form of sharp increases in government transfers financed by bond issuance. The model also assumes lump-sum taxes, so in the absence of liquidity effects Ricardian equivalence would obtain; all non-neutralities are driven entirely by the liquidity channel.

Key concepts

Liquidity-in-advance constraint : An analog of a cash-in-advance constraint in which the household must hold a weighted sum of real money balances and the real market value of bonds sufficient to finance current consumption; it always binds in the model’s equilibrium, so liquidity directly pins down output.

Price theory of money : The proposition (attributed to Keynes and labelled by Calvo 2012) that money is highly liquid partly because the nominal goods-price level is sticky, fixing the price of money in terms of goods; this insulates the real value of money from the anticipatory jumps that affect bond prices.

Bond helicopter drop : A government transfer to households financed by issuing long-term bonds (perpetuities), with no change in taxes or money supply; the term “helicopter drop of bonds” is used by the authors to parallel Friedman’s helicopter money but with bonds as the instrument.

Bond-price stabilization (non-traditional fiscal dominance) : The authors’ term for a situation in which expected fiscal bond issuance compresses bond-market liquidity and forces the central bank to expand money supply and cut the interest rate on money in order to stabilize bond prices and prevent contractionary effects, even though the central bank is not formally required to finance the deficit.

s_t (bond-to-money relative position) : A model variable defined as the log-deviation from steady state of the ratio of the real market value of bonds to real money balances; it captures the relative contribution of bonds to total portfolio liquidity and is the key endogenous state variable linking bond-price dynamics to aggregate demand.

Calvo-Phillips curve : The standard Calvo (1983) staggered-pricing supply side, used here to generate the inflation-output gap trade-off; in the paper’s notation, inflation dynamics satisfy π̇_t = δπ_t − κ(y_t − ȳ), where output gaps are driven by liquidity shortfalls rather than standard demand shocks.