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Fiscal Multipliers and Monetary Policy: Reconciling Theory and Evidence

Listed author(s):
  • Christian Bredemeier
  • Falko Juessen
  • Andreas Schabert

Fiscal multipliers are typically observed to be moderate, which should, according to standard macroeconomic theory, be associated with real interest rates increasing with government spending. However, monetary policy rates have been found to decrease, which should – in theory – lead to large multipliers. In this paper, we rationalize these puzzling observations by accounting for responses of interest rates that are more relevant for private sector transactions than the monetary policy rate. We provide evidence that real interest rates on relatively illiquid assets and interest rate spreads which measure liquidity premia tend to increase after a government spending hike. We show that an otherwise standard macro model can explain diverging interest rate responses and moderate fiscal multipliers consistent with the data by accounting for an interest rate spread that decreases with the relative demand for less liquid assets. Our analysis indicates that neither a policy rate reduction nor a fixation at the zero lower bound are sufficient to induce large fiscal multipliers.

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Paper provided by University of Cologne, Department of Economics in its series Working Paper Series in Economics with number 95.

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Date of creation: 02 Jun 2017
Handle: RePEc:kls:series:0095
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