The road to recovery: Fiscal stimulus, financial sector rehabilitation, and potential risks ahead

Abstract

The worst of the global financial crisis is behind us, but the trajectory to recovery varies widely across economies. Employing a dynamic structural multi-country model with a financial accelerator, this paper studies the roles of two important policy actions in economic recovery: fiscal stimulus and financial sector rehabilitation. The main finding is that while both factors contribute to economic recovery, the former is likely to be less effective from a medium-term perspective and may generate some negative side effects. This suggests that policy priority should be on continued financial sector rehabilitation, particularly in advanced economies. Moreover, international policy co-ordination is beneficial as it can generate spill-over effects to regional economies. We also study a potential risk to economic recovery down the road: an over-estimation of the post-crisis potential output by the monetary authorities in advanced economies. It is found that this may lead to an overly accommodative monetary policy stance, which could lead to a resurgence in inflation and hence will darken the medium-term growth prospects of the world economy.