Some countries currently face historically low interest rates on government debt due to a positive ‘convenience yield’ arising from an excess demand for safe and liquid assets. This low interest rate environment has raised interest in the role of fiscal stabilization policy. We study the convenience yield and its implications for fiscal policy in a New Keynesian model where households derive utility from government bonds. We find that the convenience yield expands the set of sustainable fiscal policies and renders countercyclical fiscal policy successful in stabilizing business cycle fluctuations. Conveniently, fiscal policies that stabilize output rather than debt are feasible, welfare enhancing and can even reduce the risk of exploding debt dynamics if the convenience yield is positive.
Keywords: convenience yield, low interest rate, fiscal policy, debt sustainability.
JEL Classifications: E32, E62, E63.