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The Government Spending Multiplier in a Deep Recession

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  • Jordan Roulleau-Pasdeloup

Abstract

The usual mechanism through which government spending can be effective in increasing GDP in a liquidity trap emphasizes the role of aggregate demand. Higher government spending generates a lower expected real interest rate through a higher real wage, which translates into higher inflation. This lower real rate increases aggregate demand. I present new evidence that casts doubt on the empirical relevance of this mechanism. In particular,liquidity traps occur exclusively in recessions, which appear to be situations where higher government spending generates less inflation than in expansion times. To rationalize this, I build a New Keynesian model with search and matching frictions in the labor market and a downward rigid nominal wage. When solved using global methods, this model generates asymmetric fluctuations of recruiting costs along the business cycle. This permits the model to generate (i) a higher government spending multiplier in recessions versus expansions and (ii) a significantly higher multiplier at the zero lower bound without relying on a counterfactually large reaction of wages and inflation, both of which are in line with empirical evidence. Decomposing the contributions of recession versus liquidity trap dynamics, I find that the latter accounts for less than half of the additional multiplier effect at the Zero Lower Bound.

Suggested Citation

  • Jordan Roulleau-Pasdeloup, 2016. "The Government Spending Multiplier in a Deep Recession," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 16.22, Université de Lausanne, Faculté des HEC, DEEP.
  • Handle: RePEc:lau:crdeep:16.22
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    Cited by:

    1. Eleni Iliopulos & François Langot & Thepthida Sopraseuth, 2014. "Welfare Cost of Fluctuations: when Labor Market Search Interacts with Financial Frictions," Documents de travail du Centre d'Economie de la Sorbonne 14042, Université Panthéon-Sorbonne (Paris 1), Centre d'Economie de la Sorbonne.
    2. Lindé, Jesper & Trabandt, Mathias, 2017. "Should We Use Linearized Models To Calculate Fiscal Multipliers?," Working Paper Series 350, Sveriges Riksbank (Central Bank of Sweden).
    3. repec:wly:jmoncb:v:50:y:2018:i:1:p:155-172 is not listed on IDEAS
    4. Taisuke Nakata, 2017. "Optimal Government Spending at the Zero Lower Bound: A Non-Ricardian Analysis," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 23, pages 150-169, January.
    5. Timothy S. Hills & Taisuke Nakata, 2018. "Fiscal Multipliers at the Zero Lower Bound: The Role of Policy Inertia," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 50(1), pages 155-172, February.

    More about this item

    Keywords

    Zero lower bound; New Keynesian; Government spending multiplier; Search and Matching Frictions;

    JEL classification:

    • E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy

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