Fiscal Multipliers: Liquidity Traps and Currency Unions

Emmanuel Farhi Iván Werning Harvard University MIT

May 2016

We provide explicit solutions for government spending multipliers during a liquidity trap and within a fixed exchange regime using standard closed and open-economy New Keynesian models. We confirm the potential for large multipliers during liquidity traps. For a currency union, we show that self-financed multipliers are small, al- ways below unity, unless the accompanying tax adjustments involve substantial static redistribution from low to high marginal propensity to consume agents, or dynamic redistribution from future to present non-Ricardian agents. But outside-financed multipliers which require no domestic tax adjustment can be large, especially when the average marginal propensity to consume on domestic goods is high or when government spending shocks are very persistent. Our solutions are relevant for local and national multipliers, providing insight into the economic mechanisms at work as well as the testable implications of these models.

1 Introduction

Economists generally agree that macroeconomic stabilization should be handled first and foremost by monetary policy. Yet monetary policy can run into constraints that impair its effectiveness. For example, the economy may find itself in a liquidity trap, where interest rates hit zero, preventing further reductions in the interest rate. Similarly, countries that belong to currency unions, or states within a country, do not have the option of an independent monetary policy. Some economists advocate for fiscal policy to fill this void, increasing government spending to stimulate the economy. Others disagree, and the is- sue remains deeply controversial, as evidenced by vigorous debates on the magnitude of

1 fiscal multipliers. No doubt, this situation stems partly from the lack of definitive empir- ical evidence, but, in our view, the absence of clear theoretical benchmarks also plays an important role. Although various recent contributions have substantially furthered our understanding, to date, the implications of standard macroeconomic models have not been fully worked out. This is the goal of this chapter. By clarifying the theoretical mechanisms in a unified way, we hope that it will help stimulate more research to validate or invalidate different aspects of the models. We solve for the response of the economy to changes in the path for government spending during liquidity traps or within currency unions using standard New Key- nesian closed and open-economy monetary models. A number of features distinguish our approach and contribution. First, our approach departs from the existing literature by focusing on fiscal multipliers that encapsulate the effects of spending for any path for government spending, instead of solving for a particular multiplier associated with the expansion of a single benchmark path for spending (e.g. an autoregressive shock process to spending). Second, we obtain simple closed-form solutions for these multipliers. The more explicit and detailed expressions help us uncover the precise mechanisms underly- ing the effects of fiscal policy and allow us to deliver several new results. Third, our analysis confirms that constraints on monetary policy are crucial, but also highlights that the nature of the constraint is also important. In particular, we draw a sharp contrast between a liquidity trap, with a binding zero-lower bound, and a currency union, with a fixed exchange rate. Finally, in addition to nominal rigidities and constraints on monetary policy, we stress the importance of incorporating financial frictions for the analysis of fiscal policy. We do so by extending the benchmark models to include both incomplete markets and non- Ricardian borrowing constrained consumers, allowing for high and heterogeneous