Abstract
SummaryWe calculate the magnitude of the government consumption multiplier in linearized and nonlinear solutions of a New Keynesian model at the zero lower bound. Importantly, the model is amended with real rigidities to simultaneously account for the macroeconomic evidence of a low Phillips curve slope and the microeconomic evidence of frequent price changes. We show that the nonlinear solution is associated with a much smaller multiplier than the linearized solution in long‐lived liquidity traps, and pin down the key features in the model which account for the difference. Our results caution against the common practice of using linearized models to calculate fiscal multipliers in long‐lived liquidity traps.
Highlights
The magnitude of the ...scal spending multiplier is a classic subject in macroeconomics
Had we considered a medium-sized model with Keynesian accelerator e¤ects in which the multiplier is in the mid-range of the empirical evidence when monetary policy is unconstrained, the multiplier could be magni...ed su¢ ciently in a long-lived liquidity trap to obtain a "...scal free lunch" for a transient spending hike
Speci...cally, we seek to characterize how the di¤erence between the multiplier in the linearized and nonlinear solutions varies with the expected duration of the liquidity trap
Summary
The magnitude of the ...scal spending multiplier is a classic subject in macroeconomics. To calculate the magnitude of the multiplier, economists typically employ a linearized version of their actual nonlinear model. When interest rates are expected to be constrained by the zero (or e¤ective) lower bound for a protracted time period, the nonlinear solution suggests a much smaller multiplier than the linearized solution of the same model. A quickly growing literature suggests that the ...scal spending multiplier can be very large when nominal interest rates are expected to be constrained by the zero (or e¤ective) lower bound (ZLB ) for a prolonged period, see e.g. The results of the above literature suggest that it is hard to reduce government debt in the short-run through aggressive government spending cuts in long-lived liquidity traps: ...scal consolidation can be self-defeating in such a situation
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