Ping He, Zehao Liu, Chengbo Xie

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This paper examines how fiscal-backed money can provide additional liquidity to consumers and mitigate liquidity shortages in an economy with banks, where agents face idiosyncratic liquidity shocks but are not fully insured. The government issues fiat money and creates real value for it through taxation, accepting money for tax payments. This increases consumers' wealth and enhances the demand for liquidity, thereby incentivizing banks to provide more liquidity and alleviate the liquidity shortage problem. The paper argues that the fiscal solution is more incentive-compatible than liquidity requirements, as it encourages banks to voluntarily increase liquidity without direct regulation.

Additionally, the study shows how the fiscal surplus plays a crucial role in equilibrium allocation. Increasing taxes to increase the fiscal surplus and real value of money can reduce investment, thus influencing the demand for liquidity in the economy. A proper tax rate is crucial for achieving the socially optimal allocation, while improper tax rates can cause inefficiencies such as overinvestment or underinvestment. The study also explores how fiscal policy can affect private information production and how misaligned tax policies can create constraints on optimal fiscal policy. The results highlight that the government must carefully balance tax rates to avoid triggering private information production, which could destabilize the financial system.