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How do financial frictions affect the spending multiplier during a liquidity trap?





We show that credit market imperfections substantially increase the government-spending multiplier when the economy enters a liquidity trap. This ?finding is explained by the tight association between capital goods and ?rms?collateral, a relationship that we highlight as the capital-accumulation channel. During a liquidity trap, a government spending expansion reduces the real interest rate, leading to a period of cheap credit. Entrepreneurs use this time to accumulate capital, which persistently improves their balance sheets and reduces their future costs of credit. A public spending expansion can thus encourage private investment, yielding consequently a large spending multiplier. This effect is further reinforced by Fisher?s debt- de?ation channel.

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Paper provided by Ghent University, Faculty of Economics and Business Administration in its series Working Papers of Faculty of Economics and Business Administration, Ghent University, Belgium with number 12/779.

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Length: 39 pages
Date of creation: Mar 2012
Date of revision:
Handle: RePEc:rug:rugwps:12/779
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