How much inflation can fiscal policy create? Separating household heterogeneity and liquidity

Abstract

A key determinant of monetary-fiscal interactions in Heterogeneous Agent New Keynesian (HANK) models is the liquidity value of public debt and its effect on interest rate dynamics. Yet, while household heterogeneity shapes this channel, it doesn't pin it down. In both analytically tractable and quantitative 2-asset HANK models, asset market assumptions unrelated to standard micro moments give rise to disparate implications of fiscal policy for inflation, as well as model determinacy and fiscal self-financing. To address this issue, I propose a simple model extension and discipline it with macro-level evidence on the relationship between public debt and treasury returns. This moderates the inflationary impact of public debt dynamics but does not render it negligible. After large fiscal shocks, it can still generate persistently elevated ``last mile'' inflation.