Working Paper

Unconventional Monetary Policy and Local Fiscal Policy

Abstract: Following the onset of the pandemic, the Federal Reserve employed an unconventional monetary policy that directly intervened in municipal bond markets. We characterize the fiscal and macroeconomic implications of such central bank actions in a New Keynesian model of a monetary union. We assume that state and local governments are subject to a loan-in-advance constraint, reflecting that with lumpy cash flows, they often finance a fraction of expenditures by issuing short-term bonds. The municipal debt is held by financial intermediaries, who also supply credit to the private sector. Direct central bank purchases can transmit to the economy through two main channels: 1) by alleviating cash flow problems of the regional governments and 2) by accelerating lending to the private sector if credit constraints ease more broadly. By quantifying the relative importance of these channels, we highlight that the central bank’s actions lead to sizable increases in private investment but have more muted effects on state and local government expenditures. In addition, we also show the transmission of direct federal government aid through intergovernmental transfers is markedly different from unconventional policy.

Keywords: monetary policy; quantitative easing; municipal debt; Municipal Liquidity Facility (MLF);

JEL Classification: E52; E58; E62;

https://doi.org/10.18651/RWP2022-15

Bibliographic Information

Provider: Federal Reserve Bank of Kansas City

Part of Series: Research Working Paper

Publication Date: 2022-11-07

Number: RWP 22-15