Saturday, October 26, 2013

Fiscal Multipliers In A Liquidity Trap

Mark Thoma is attending a NBER session in which several interesting papers have been presented.  This paper is very timely, although a bit wonkish, because it provides an answer to an important question that has been debated by economists.  Some economists have argued against the use of fiscal stimulus in a recession by suggesting that government deficits will not stimulate the economy since a dollar of additional government spending will produce less than a dollar of aggregate demand.  This assumes that the fiscal multiplier is less than one.  Others have argued that the fiscal multiplier is greater than one when monetary policy is limited by the zero lower bound.  At the zero lower bound nominal interest rates cannot fall below zero.  On the other hand, real interest rates can be negative because of inflation.  The higher the rate of inflation, the lower the rate of real interest rates,  which will raise the rate of aggregate demand.

The conclusion reached in this study suggests that the fiscal multiplier is greater than unity and that government deficits will increase aggregate demand in a country with its it own currency at the zero lower bound.  The multiplier will also be greater than unity in a currency union but the mechanism will be different than it is for a country with its own currency.  In a currency union it is not possible to increase demand via currency depreciation and rising exports.  Transfer payments, however, within the currency union will have a value greater than one.  

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