Government Spending Multipliers with the Real Cost Channel

Abstract

I introduce the real cost channel in the benchmark New Keynesian model to study government spending multipliers. Even though this new model shows previous evidence that the output gap multiplier in normal times can be overestimated by ignoring the cost channel, I provide a simple Markov chain representation closed-form solution. Nevertheless, in liquidity traps, it fundamentally departs from previous implications with the nominal cost channel that the deflation pressure can be exacerbated in the presence of real cost channel and then the output gap multiplier can be lower. In particular, after the zero lower bound has subsided, the long-run government spending policy is favored since it can enlarge the short term output gap multiplier. Finally, I leverage this new framework to confirm the robust role of the real cost channel on policy multipliers.