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The Effects of Secondary Markets and Unsecured Credit on Inflation Dynamics

Dominguez, Begona and Gomis-Porqueras, Pedro (2016): The Effects of Secondary Markets and Unsecured Credit on Inflation Dynamics.

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We consider an environment with stochastic trading opportunities and incomplete markets and analyze how trading in secondary markets for government debt and access to unsecured credit affect inflation. When secondary markets are not active, {there exists} a unique monetary steady state where public debt does not affect inflation dynamics. In contrast, we find that when agents trade in secondary markets, agents are buying government bonds above their fundamental value. As a result, Ricardian equivalence does not hold and multiple steady states can not be ruled out as government bonds generate a liquidity premium. In particular, we find that the gross interest payment on public debt is non-linear in bond holdings. {Because of this liquidity premium, real government bonds matter for inflation.} To rule out real indeterminacies, we show that active monetary policy is more likely to deliver a unique monetary steady state regardless the stance of fiscal policy. Moreover, trading in secondary markets further amplify the effectiveness of active monetary policies in reducing steady state inflation. Finally, we show that a spread-adjusted Taylor rule delivers a unique steady state, thus ruling out real indeterminacies.

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