Abstract
This paper demonstrates how adding nominal wage rigidity to a standard, closed economy sticky price model can by itself create a mechanism by which increases in government spending cause increases in consumption. The increase in output arising from government purchases puts upward pressure on the price level. At a fixed short-run nominal wage, this bids down the real wage, which leads producers to increase labor demand. Increased labor demand allows households to both finance the tax bill associated with the government spending as well as increase their own consumption. Our approach does not rely upon existing ingredients for generating large fiscal multipliers, such as the zero lower bound, borrowing constrained households or an interaction between consumption and government purchases in the utility function.
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