Sovereign illiquidity and recessions

This paper examines the importance of sovereign debt market liquidity in a New Keynesian environment with wage rigidities and financial frictions ala Kiyotaki and Moore (2012). The analysis implies that, independently of credit risk, a decrease in the liquidity of government bonds has significant detrimental effects on output, employment and investment. A shut down of sovereign debt market for one quarter generates a 7% drop in output and investment as well as a 2% increase in unemployment. Also, in a framework where the only sources of variation are private and public liquidity shocks, sovereign bond market illiquidity can account for most of the output drop in Italy between 2011q2 and 2013q1. These results suggest that European Central Bank's (ECB) temporary policies taken in 2012 aimed at rising liquidity seem to have prevented a more prolonged and deeper economic downturn. (C) 2020 Elsevier B.V. All rights reserved.