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Can Fiscal Stimulus Overcome the Zero Interest-Rate Bound?: A Quantitative Assessment

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  • Kenneth Lewis

    ()
    (Department of Economics,University of Delaware)

  • Laurence Seidman

    ()

Abstract

This paper provides a quantitative assessment of the use of fiscal stimulus to achieve full recovery from a severe recession when the potency of monetary policy weakens after hitting its zero interest-rate bound. By contrast, most of the numerous recent zero interest-rate bound papers have ignored the use of fiscal stimulus, preferring to examine whether monetary policy alone can revive the economy despite the zero bound. We obtain our estimates by adapting and simulating a macro-econometric model that has been recently econometrically estimated, updated, and statistically tested using U.S. times series data. By contrast, most of the recent zero bound papers do not use an econometrically-estimated model. If the U.S. economy were hit with a large negative demand shock that drives the unemployment rate up to 7.9%, we estimate that even aggressive monetary policy that drives long-term interest rates to near zero would reduce the unemployment rate only to 6.7%. Full recovery would be achieved, however, if the aggressive monetary policy were complemented by sufficient fiscal stimulus in the form of cash transfers or income tax cuts to households. We estimate that a quarterly transfer to households that peaks at 2.7% of quarterly GDP and phases out gradually as it is repeated over seven quarters (so that the cumulative transfer is roughly 12% of quarterly GDP) would reduce the unemployment rate in such a recession by nearly an additional percentage pointC from 6.7% to 5.9%.

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File URL: http://graduate.lerner.udel.edu/sites/default/files/ECON/PDFs/RePEc/dlw/WorkingPapers/2005/UDWP2005-19.pdf
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Bibliographic Info

Paper provided by University of Delaware, Department of Economics in its series Working Papers with number 05-19.

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Length: 32 pages
Date of creation: 2005
Date of revision:
Handle: RePEc:dlw:wpaper:05-19

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Web page: http://www.lerner.udel.edu/departments/economics/department-economics/
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  1. David Reifschneider & John C. Williams, 2000. "Three lessons for monetary policy in a low-inflation era," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 936-978.
  2. Ben S. Bernanke & Vincent R. Reinhart, 2004. "Conducting Monetary Policy at Very Low Short-Term Interest Rates," American Economic Review, American Economic Association, vol. 94(2), pages 85-90, May.
  3. Alan J. Auerbach & Maurice Obstfeld, 2005. "The Case for Open-Market Purchases in a Liquidity Trap," American Economic Review, American Economic Association, vol. 95(1), pages 110-137, March.
  4. Fumio Hayashi, 2002. "Commentary : Is there a role for discretionary fiscal policy?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 163-172.
  5. Ben S. Bernanke & Vincent R. Reinhart & Brian P. Sack, 2004. "Monetary Policy Alternatives at the Zero Bound: An Empirical Assessment," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 35(2), pages 1-100.
  6. Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235.
  7. Adam S. Posen, 1998. "Restoring Japan's Economic Growth," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 35.
  8. Lars E. O. Svensson, 2003. "Monetary Policy and Real Stabilization," NBER Working Papers 9486, National Bureau of Economic Research, Inc.
  9. Seidman, Laurence S & Lewis, Kenneth A, 2002. "A New Design for Automatic Fiscal Policy," International Finance, Wiley Blackwell, vol. 5(2), pages 251-84, Summer.
  10. Wieland, Volker & Coenen, Günter, 2004. "Exchange-rate policy and the zero bound on nominal interest," CFS Working Paper Series 2004/14, Center for Financial Studies (CFS).
  11. Bennett T. McCallum, 2000. "Theoretical analysis regarding a zero lower bound on nominal interest rates," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, pages 870-935.
  12. Coenen, Günter & Wieland, Volker, 2004. "Exchange-rate policy and the zero bound on nominal interest rates," Working Paper Series 0350, European Central Bank.
  13. Laurence Seidman, 2001. "Reviving Fiscal Policy," Challenge, M.E. Sharpe, Inc., vol. 44(3), pages 17-42, May.
  14. Kenneth N. Kuttner & Adam S. Posen, 2001. "The Great Recession: Lessons for Macroeconomic Policy from Japan," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 32(2), pages 93-186.
  15. Martin Feldstein, 2002. "Commentary : Is there a role for discretionary fiscal policy?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 151-162.
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