Fiscal Policy Interventions at the Zero Lower Bound

We build on a New Keynesian Dynamic Stochastic General Equilibrium (DSGE) model to explore the macroeconomic consequences of fiscal expansionary shocks during the economic crisis of 2008 in the eurozone. In this setting, we find that the big four eurozone economies (France, Germany, Italy, and Spain) can effectively escape from their liquidity trap through fiscal policy interventions caused by government purchases. We estimate the government spending multiplier to be above 1.8 when this policy is associated with a long-term commitment to keeping the nominal interest rate at the zero lower bound, as suggested by Krugman (1998). Notably, the short-term deficit effect on the budget balance can be offset five years after the implementation of a large spending program. We also show that alternative policies with tax cuts that expand the supply do not appear to have the same power in the short run. Moreover, we provide novel empirical evidence that a large government debt renders a government spending policy ineffective.