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Is there a fiscal free lunch in a liquidity trap?

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  • Christopher J. Erceg
  • Jesper Linde

Abstract

This paper uses a DSGE 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. But 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.

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Bibliographic Info

Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 1003.

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Date of creation: 2010
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Handle: RePEc:fip:fedgif:1003

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Keywords: Monetary policy ; Fiscal policy ; Liquidity (Economics);

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  1. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
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Citations

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Cited by:
  1. Stähler, Nikolai & Thomas, Carlos, 2012. "FiMod — A DSGE model for fiscal policy simulations," Economic Modelling, Elsevier, vol. 29(2), pages 239-261.
  2. Michael Woodford, 2010. "Simple Analytics of the Government Expenditure Multiplier," NBER Working Papers 15714, National Bureau of Economic Research, Inc.
  3. Gunter Coenen & Roland Straub & Mathias Trabandt, 2012. "Gauging the effects of fiscal stimulus packages in the Euro area," International Finance Discussion Papers 1061, Board of Governors of the Federal Reserve System (U.S.).
  4. repec:ecb:ecbwps:20111429 is not listed on IDEAS
  5. Ethan Ilzetzki & Enrique G. Mendoza & Carlos A. Végh Gramont, 2011. "How Big (Small?) Are Fiscal Multipliers?," IMF Working Papers 11/52, International Monetary Fund.
  6. Julien Albertini & Arthur Poirier & Jordan Roulleau-Pasdeloup, 2014. "The composition of government spending and the multiplier at the Zero Lower Bound," SFB 649 Discussion Papers SFB649DP2014-017, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  7. Merola, Rossana, 2010. "Financial frictions and the zero lower bound on interest rates: a DSGE analysis," MPRA Paper 29365, University Library of Munich, Germany.
  8. Mertens, Karel & Ravn, Morten O., 2010. "Fiscal Policy in an Expectations Driven Liquidity Trap," CEPR Discussion Papers 7931, C.E.P.R. Discussion Papers.
  9. Giancarlo Corsetti & Michael P. Devereux & Luigi Guiso & John Hassler & Gilles Saint-Paul & Hans-Werner Sinn & Jan-Egbert Sturm & Xavier Vives, 2010. "Chapter 3: From Fiscal Rescue to Global Debt," EEAG Report on the European Economy, CESifo Group Munich, vol. 0, pages 71-100, 02.
  10. Douglas Sutherland & Peter Hoeller & Rossana Merola, 2012. "Fiscal Consolidation: Part 1. How Much is Needed and How to Reduce Debt to a Prudent Level?," OECD Economics Department Working Papers 932, OECD Publishing.

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