Incomplete Financial Markets, Irreversibility of Investments and Fiscal and Monetary Policy Instruments

In this paper, we analyse the use of fiscal and monetary instruments to improve long-run welfare when productive investment is irreversible and uncollateralizable and there is no insurance. Only fiat money or government issued bonds provide self-insurance. We demonstrate that an increase in precautionary savings reduces irreversible productive investment. Hence, subsidies to promote productive but irreversible investment should be financed in such a way that they do not reduce insurance capability. When lump-sum subsidies are high, a consumption tax is likely to be more redistributive and thus more consumption smoothing than are the other sets of instruments analysed in our model.