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What fiscal policy is effective at zero interest rates?

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  • Gauti B. Eggertsson

Abstract

Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures. Another example is a cut in capital taxes. This tax cut deepens a recession because it encourages people to save instead of spend at a time when more spending is needed. Fiscal policies aimed directly at stimulating aggregate demand work better. These policies include 1) a temporary increase in government spending; and 2) tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply, such as an investment tax credit or a cut in sales taxes. The results are specific to an environment in which the interest rate is close to zero, as observed in large parts of the world today.

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Bibliographic Info

Paper provided by Federal Reserve Bank of New York in its series Staff Reports with number 402.

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Date of creation: 2009
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Handle: RePEc:fip:fednsr:402

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Related research

Keywords: Fiscal policy ; Interest rates ; Taxation ; Government spending policy;

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