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The Government Spending Multiplier in a Deep Recession

Listed author(s):
  • Jordan Roulleau-Pasdeloup

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.

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Paper provided by Université de Lausanne, Faculté des HEC, DEEP in its series Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) with number 16.22.

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Length: 58 pp.
Date of creation: Nov 2016
Handle: RePEc:lau:crdeep:16.22
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Université de Lausanne, Faculté des HEC, DEEP, Internef, CH-1015 Lausanne

Phone: ++41 21 692.33.20
Web page: http://www.hec.unil.ch/deep/publications/cahiers/series
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