Monetary and Fiscal Policy Interactions under Debt Collateralization

This paper studies optimal monetary and fiscal policy rules when government debt and capital serve as collateral in financial markets. When firms face tighter borrowing constraints, bonds and capital carry high premiums leading to distorted investment decisions and lower production. In a New Keynesian model with this financial friction, I examine whether and how monetary policy should respond to collateral premiums. I find that optimal monetary policy should lower interest rates when collateral premiums increase. I also find that fiscal policy complements this by lowering tax rates as debt increases, boosting firms’ productivity and labor demand, driving up collateral needs and premiums—and further raising bond prices to finance expanded borrowing. I find that this coordination achieves better welfare outcomes with less aggressive policy interventions than traditional frameworks, but at the cost of higher consumption volatility. I show how financial frictions fundamentally alter optimal policy design, particularly through the interaction between collateral values, inflation, and real economic activity. Moreover, the optimal long-run tax structure features a positive tax on capital and a negative tax (i.e., a subsidy) on labor. These corrective taxes curb firms’ demand for capital as collateral and reduce their reliance on collateralized borrowing through a labor subsidy. While this departs from the zero capital tax prescription of standard models, it aligns with findings from frameworks with imperfect financial markets.