Sovereign illiquidity and recessions

Abstract

Motivated by the striking increase in sovereign spreads and the subsequent recession in Europe during 2011, I examine the importance of sovereign debt liquidity in a New Keynesian environment with wage rigidities and nancial frictions a la Kiyotaki and Moore (2012). My main ndings imply that, independently of credit risk, a decrease in the liquidity of government bonds has signi cant detrimental e ects on output, employment, investment, and equity prices. Therefore, this framework suggests that ECB policies taken in 2012 aimed at introducing liquidity seem to be the desired measures, at least temporally until conventional monetary policy became e ective again.