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How do financial frictions affect the spending multiplier during a liquidity trap?

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  • J. A. CARRILLO

    ()

  • C. POILLY

    ()

Abstract

We show that credit market imperfections substantially increase the government-spending multiplier when the economy enters a liquidity trap. This finding is explained by the tight association between capital goods and rms’collateral, a relationship that we highlight as the capital-accumulation channel. During a liquidity trap, a government spending expansion reduces the real interest rate, leading to a period of cheap credit. Entrepreneurs use this time to accumulate capital, which persistently improves their balance sheets and reduces their future costs of credit. A public spending expansion can thus encourage private investment, yielding consequently a large spending multiplier. This effect is further reinforced by Fisher’s debt- de‡ation channel.

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Bibliographic Info

Paper provided by Ghent University, Faculty of Economics and Business Administration in its series Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium with number 12/779.

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Length: 39 pages
Date of creation: Mar 2012
Date of revision:
Handle: RePEc:rug:rugwps:12/779

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Keywords: Financial Frictions; Zero Lower Bound; Fiscal Policy;

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Cited by:
  1. Villa, Stefania, 2013. "Financial frictions in the euro area: a Bayesian assessment," Working Paper Series 1521, European Central Bank.
  2. Merola, Rossana, 2014. "The role of financial frictions during the crisis: an estimated DSGE model," Dynare Working Papers 33, CEPREMAP.
  3. Javier Andrés & José Emilio Boscá & Javier Ferri, 2011. "Household Leverage and Fiscal Multipliers," Working Papers 1103, International Economics Institute, University of Valencia.
  4. Giovanni Melina & Stefania Villa, 2013. "Fiscal Policy and Lending Relationships," IMF Working Papers 13/141, International Monetary Fund.
  5. Julien Albertini & Arthur Poirier, 2014. "Unemployment benefits extensions at the zero lower bound on nominal interest rate," SFB 649 Discussion Papers SFB649DP2014-019, Sonderforschungsbereich 649, Humboldt University, Berlin, Germany.
  6. Flotho, Stefanie, 2012. "Monetary and Fiscal Policy in a Monetary Union under the Zero Lower Bound constraint," Annual Conference 2012 (Goettingen): New Approaches and Challenges for the Labor Market of the 21st Century 62028, Verein für Socialpolitik / German Economic Association.
  7. Stefanie Flotho, 2012. "Monetary and Fiscal Policy in a Monetary Union under the Zero Lower Bound constraint," Discussion Paper Series 20, Department of International Economic Policy, University of Freiburg, revised Jun 2012.

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