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Federal Reserve Bank of St. Louis
Working Papers
Liquidity Premiums on Government Debt and the Fiscal Theory of the Price Level
Aleksander Berentsen
Christopher J. Waller

We construct a dynamic general equilibrium model where agents use nominal government bonds as collateral in secured lending arrangements. If the collateral constraint binds, agents price in a liquidity premium on bonds that lowers the real rate on bonds. In equilibrium, the price level is determined according to the fiscal theory of the price level. However, the market value of government debt exceeds its fundamental value. We then examine the dynamic properties of the model and show that the market value of the government debt can fluctuate even though there are no changes to current or future taxes or spending. The price dynamics are driven solely by the liquidity premium on the debt.

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Aleksander Berentsen & Christopher J. Waller, Liquidity Premiums on Government Debt and the Fiscal Theory of the Price Level, Federal Reserve Bank of St. Louis, Working Papers 2017-8, 29 Mar 2017.
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Keywords: Price level; Fiscal Policy; Liquidity
DOI: 10.20955/wp.2017.008
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