Could Fiscal Policies Overcome a Deep Recession at the Zero Lower Bound?

This paper sets up a New Keynesian model in which the monetary authority implements a zero lower bound interest rate policy, and uses it to explore whether the supportive fiscal instruments (including expansionary government spending, a payroll tax cut, and a financial assets tax cut) are effective in overcoming a deep recession. The salient feature of this study is that it provides a new dynamic viewpoint of regime switching by evaluating each of several supportive fiscal policies in terms of their performance in alleviating a deep recession. Two main findings emerge from the analysis. First, when the monetary authority implements the zero lower bound interest rate policy to dampen the negative natural rate shock, the economy will sink into a deep recession with deflation. Second, to overcome the deep recession, of the three supportive fiscal tools (i.e., expansionary government spending, a payroll tax cut, and a financial assets tax cut), only expansionary government spending is effective in alleviating the deep recession. More specifically, the implementation of fiscal policy in the form of either the payroll tax cut or the financial assets tax cut will only further deepen the recession.