Is There a Fiscal Free Lunch in a Liquidity Trap?

Abstract

In this paper, we use a dynamic stochastic general equilibrium model to examine the effects of an expansion in government spending in a liquidity trap. If the liquidity trap is very prolonged, the spending multiplier can be much larger than in normal circumstances, and the budgetary costs minimal. However, given this fiscal free lunch, it is unclear why policymakers would want to limit the size of fiscal expansion. Our paper addresses this question in a model environment in which the duration of the liquidity trap is determined endogenously, and depends on the size of the fiscal stimulus. We show that even if the multiplier is high for small increases in government spending, it may decrease substantially at higher spending levels; thus, it is crucial to distinguish between the marginal and average responses of output and government debt.

Challenges for Central Banks’ Macro Models

“…switches in signs for the policy shocks). This …nding is consistent with Erceg and Lindé [65], who argue that a low slope of the Phillips curve is consistent with the development during the recent crisis where in ‡ation and in ‡ation expectations have fallen very moderately despite large contractions in output. It is also consistent with many recent papers which have estimated similar DSGE models, see e.g.…”

The composition of government spending and the multiplier at the zero lower bound

“…While our benchmark calibration is in line with some of the empirical evidence, higher values for ψ = 40 cannot be ruled out (see e.g. the discussion in Erceg & Lindé (2010) and the references therein). Since ψ indexes price rigidity, a higher value for this parameter will imply a lower ∂π t ∂mc t .…”

Global Imbalances and Policy Wars at the Zero Lower Bound

“…Keynes (1936), Krugman (1998), Eggertsson and Woodford (2003), Christiano, Eichenbaum and Rebelo (2011), Guerrieri and Lorenzoni (2011), Eggertsson and Krugman (2012), Werning (2012), and Correia, Farhi, Nicolini and Teles (2013 Farhi and Werning (2012), Cook andDevereux (2013a), (2013b) and (2014), Devereux and Yetman (2014), Benigno and Romei (2014) and Erceg and Lindé (2014)). While many of these papers share similar themes, our paper elucidates the link between the size and distribution across countries of the global recession and net foreign asset positions, with our Metzler diagram in quantities, allows for permanent liquidity traps and capital flows (global imbalances) via an OLG model, and introduces a distinction between risky and safe assets.…”