Fiscal policy and asset purchases in
a liquidity constrained economy
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Abstract
This thesis modifies the basic neoclassical DSGE model of Kiyotaki and Moore (2012) by
introducing a government which levies distortionary taxes on wages and dividends, consumes
general output, issues money, and holds privately-issued equity. The thesis answers two
questions - Can discretionary policy relieve the effects of liquidity constraints that limit
investment, and thereby stimulate economic activity in normal times? Can discretionary
policy ameliorate the effects of an exogenous liquidity shock?
Including distortionary taxes is a unique modification within a branch of literature that
extends the work of KM and studies liquidity shocks. The thesis belongs to a branch of this
literature which modifies KM's basic model, but none of these papers have distortionary
taxes and none examine fiscal policy. The thesis extends the literature with a novel variant
of the basic KM model and with a novel set of policies against a liquidity shock.
The results are as follows. Firstly, if money supply is constant and government spending
varies to always balance the fiscal budget, then across-the-board tax cuts persistently
stimulate the economy and a cut in the rate of tax on dividends ameliorates a liquidity
shock without additional distortions. These responses are robust to the model's calibration.
Secondly, an increase in government spending, financed by more taxes or selling equity
holdings, persistently worsens economic activity and exacerbates a liquidity shock; financing
the policies is what brings adverse results. Thirdly, the direct effects of a government
equity purchase programme are short-lived - investment rises and new equity is added to
the market which partially offsets the government's purchase. Financing the programme
with spending cuts do less harm than raising taxes. Adding monetary expansion to the
policy mix improves aggregate supply but reduces aggregate demand. When used against
a liquidity shock, the programme makes a positive but short-lived difference