Rent-Seeking and the Choice of Public Liquidity

I study public liquidity provision in a liquidity-constrained economy in which government policy is decided by politicians subject to rent-seeking and electoral constraints. Public interventions are modeled as a choice between direct fiscal transfers to constrained entrepreneurs and non-targeted interventions through interest rate manipulation. The political equilibrium introduces time inconsistency in government policy as well as institutional constraints that place bounds on the size of public interventions. The liquidity provision patterns emerging from the political equilibrium involve several types of inefficiencies, compared to a benevolent government benchmark. First, the need to extract revenue for political rents increases equilibrium tax distortions. Second, interest rate interventions are part of the equilibrium even though they are not part of the benevolent government policy. This happens of the additional political and electoral constraints. Third, rent-seeking can lead to suboptimally low levels of public liquidity provision, as tax revenue is diverted towards rents.