Efficacy of Fiscal Policy Changes in a Liquidity Trap: Does Household Heterogeneity Matter?

This paper aims to provide a better understanding of the efficacy of fiscal policy and distortionary-tax cuts in a zero interest rate environment. Output is demand determined in a liquidity trap (as in sticky price models, output adjusts to the demand in the economy) and demand is usually not adequate. This is the main problem and policies aimed at increasing production capacity or the potential output level as in the Neoclassical theory, would not be directly relevant in a zero interest rate case. The paper is mainly concerned with the question of whether fiscal policy can reverse an output collapse in a recession such as 2008. This paper analyses the effective role of the countercyclical fiscal policy argued in the standard Keynesian models in the special case that conventional monetary policy is not effective. The paper deviates from the ad-hoc nature of lump-sum taxes and focuses on distortionary tax cuts that have been popular in policy discussions lately. The model includes a variety of taxes that distort choices of households with heterogeneous consumption behaviour. It considers the income and substitution effects of fiscal changes for different households. The paper uses a standard New-Keynesian model, but allows for heterogeneity in consumption behaviour by including Keynesian (rule-of-thumb) households that consume their current after tax income. The paper studies how the fraction of the Keynesian households interacting with nominal rigidities, in an economy with distortionary taxes, changes the effectiveness of countercyclical fiscal policy. As a starting point, the model employs labour-income tax cuts to analyse the effectiveness of tax cuts for recovery. Further, the model employs a range of other distortionary taxes (such as income tax and sales tax changes, as has been offered by many economists during the 2008 crisis) for a richer fiscal policy setup, and the automatic stabilizers analysis as well as the financing method. I look if the estimated effects change in a more realistic taxation and household set-up where distortionary taxes interact with fraction of the Keynesian agents. The paper considers a banking shock to put the economy into a recession. The New-Keynesian (NK) dynamic stochastic general equilibrium (DSGE) model is built on Chari et al. (2000), Christiano (2004), Woodford (2003), Smets and Wouters (2007), Gali et al. (2007) and Eggertsson (2010). The paper puts the heterogeneity idea of Gali et al. (2007) into the zero-interest rate framework of Eggertsson and Woodford (2003). By including nominal rigidities and hand-to-mouth agents (via the direct demand effect) into the model, I primarily focus on and expect to see the positive effect from this countercyclical discretionary fiscal policy that has been controversial in recent studies. As a matter of fact, compared to the benchmark Eggertsson (2010) model, the paper finds significant effects for consumption and / or labour-income taxes. If we had positive interest rate, under normal circumstances - absent any shock, the monetary authority would cut taxes aggressively (more than proportional) in order to decrease real interest rates, and thus increase the demand in economy (CB following the Taylor principle). However, if the ZLB binds, the monetary authority is not able to cut the nominal rates to change the real rate of interest. Therefore, the AD curve becomes upward sloping. This means a low inflation will always imply a higher real rate of interest and thus lower demand, and a high inflation will give low real rate because central bank is not able to respond. The idea is that, when there is a tax cut, nominal income from work goes up and that increases willingness to work more, to get more money for each unit of labour supply. Increasing labour supply, decreases real wages (marginal cots down). Lower real wages means lower input cost which increases supply and decreases prices. Therefore, we observe a deflationary pressure. Deflationary expectations, in return, increase the real interest rate which decreases demand and spending in the current period.