Effect of Monetary Policy on Government Spending Multiplier

This paper empirically examines the effect of the monetary policy stance toward inflation on the government spending multiplier when the nominal interest rate is not bound to zero. We estimate a time-varying coefficient vector autoregressive (TVC-VAR) model using 2000:Q1 to 2019:Q3 quarterly data of Korea, whose policy rate is distant from zero. We find that the medium-run government spending multiplier is dampened as the anti-inflationary stance of the central bank becomes more aggressive. The TVC-VAR estimate shows that Korea’s monetary policy became more hawkish until 2009 and attenuated afterward, which is consistent with the narrative evidence from the Bank of Korea. Meanwhile, the medium-run government spending multiplier declined until 2009, after which it started to increase. Our empirical result supports existing theoretical work such as Christiano et al. (2011) that posits a negative relationship between the degree of the monetary authority’s anti-inflationary stance and the size of government spending multipliers.