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Asset supply and liquidity transformation in HANK

We study how the financial sector affects fiscal and monetary policy in heterogeneous agent New Keynesian (HANK) economies. We show that, in a large class of models of financial intermediation, relevant features of the financial sector are summarized by the elasticities of a liquid asset supply function. The financial sector in these models affects aggregate responses only through its ability to perform liquidity transformation (i.e., issue liquid assets to finance illiquid capital). If liquid asset supply responds inelastically to returns on capital (low cross-price elasticities), disturbances in the liquid asset market generate large responses in aggregate demand through adjustments in capital prices. Assumptions about the financial sector are not innocuous quantitatively. In commonly used setups that imply different liquid asset supply elasticities, aggregate output responses to an unexpected deficit-financed government transfer can differ by a factor of three.

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https://doi.org/10.20955/wp.2022.038