State Dependent Government Spending Multipliers: Downward Nominal Wage Rigidity and Sources of Business Cycle Fluctuations

We consider a New Keynesian model with downward nominal wage rigidity (DNWR) and show that government spending is much more effective in stimulating output in a low-inflation recession relative to a high-inflation recession. The government spending multiplier is large when DNWR binds, but the nature of recession matters due to the opposing response of inflation. In a demand-driven recession, inflation falls, preventing real wages from falling, leading to unemployment, while inflation rises in a supply-driven recession limiting the consequences of DNWR on employment. We document supporting empirical evidence, using both historical time series data and cross-sectional data from U.S. states.