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

  • Julio Carrillo

    (University of Ghent)

  • Celine Poilly

    (University of Lausanne)

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 firms' 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-deflation channel. (Copyright: Elsevier)

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File URL: http://dx.doi.org/10.1016/j.red.2013.01.004
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Article provided by Elsevier for the Society for Economic Dynamics in its journal Review of Economic Dynamics.

Volume (Year): 16 (2013)
Issue (Month): 2 (April)
Pages: 296-311

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Handle: RePEc:red:issued:12-54
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