The optimal composition of public spending in a deep recession

Abstract

We study optimal fiscal policy in an economy plunged into a deep recession characterized by a liquidity trap, and in which the government can allocate spending both to consumption and investment goods. Public investment increases the stock of public capital subject to a time-to-build constraint. The zero lower bound on the nominal interest rate binds as a result of a large shock that increases households’ desire to save in the risk-free asset, pushing the natural rate of interest below zero. Under nominal rigidities and sub-optimal monetary policy, the shock leads to a large decline in private consumption and investment. We show that the optimal response to such a shock is to temporarily raise public spending above the level that would be dictated by classical principles, and to tilt its composition towards public investment. This compositional shift lasts well after the natural rate has ceased to be negative. Our results suggest that the American Recovery and Reinvestment Act of 2009 was insufficiently oriented towards public investment.