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Sovereign Illiquidity and Recessions

Motivated by the European debt crisis and European Central Bank (ECB) measures to restore sovereign bond market liquidity, I examine the importance of sovereign debt liquidity in a New Keynesian environment with wage rigidities and financial frictions à la Kiyotaki and Moore (2012). The analysis implies that, independently of credit risk, a decrease in the liquidity of government bonds has significant detrimental effects on output, employment and investment. A shut down of sovereign debt market for one quarter generates a 7% drop in output and investment as well as a 2% increase in unemployment. Sovereign bond market illiquidity can account for 86% of the output drop in Italy between 2011q2 and 2013q1. ECB temporally policies taken in 2012 aimed at rising liquidity seem to have prevented a longer and deeper economic downturn.