Optimal Policy with Liquidity Frictions

The recent financial crisis has shown that liquidity fluctuations in asset markets can have a large impact on the real economy. Many central banks started unconventional monetary policies in 2008, but we still have little understanding of optimal monetary and fiscal policies in such an environment. To fill this gap, we develop a tractable optimal policy plan for a heterogeneous agent model with liquidity frictions. The model features incomplete markets for investment opportunities and resaleability frictions of privately issued assets. In steady state, taxation may not be needed and the optimal policy can achieve the first-best allocation by a variant of "Friedman Rule'': buying some private claims by issuing liquid government bonds and use the return to pay bond holders. The calibration shows that the optimal policy plan can raise permanent output by 1.7% compared to a constant supply of government bonds. In response to adverse liquidity shocks, the optimal policy prescribes both taxation and unconventional monetary policies to prevent a flight to liquidity. Taxation is important in the wealth redistribution to avoid devaluing government bonds