Is There a Fiscal Free Lunch in a Liquidity Trap?

61 Pages Posted: 18 Jan 2010

See all articles by Christopher J. Erceg

Christopher J. Erceg

Board of Governors of the Federal Reserve System

Jesper Lindé

Sveriges Riksbank - Research Division

Date Written: January 2010

Abstract

This paper uses a DSGE model to examine the effects of an expansion in government spending in a liquidity trap. The spending multiplier can be much larger than in the normal situation if the liquidity trap is very prolonged, and the budgetary costs minimal. But given this "fiscal free lunch," it is unclear why policymakers would want to limit the size of fiscal expansion. Our paper addresses this question in a model environment where the duration of the liquidity trap is determined endogenously, and depends on the size of the fiscal stimulus. We show that even if the multiplier is high for small increases in government spending, it may decrease substantially at higher spending levels; thus, it is crucial to distinguish between the average and marginal multiplier.

Keywords: DSGE Model, Fiscal Policy, Liquidity Trap, Monetary Policy, Zero Bound Constraint

JEL Classification: E52, E58

Suggested Citation

Erceg, Christopher J. and Linde, Jesper, Is There a Fiscal Free Lunch in a Liquidity Trap? (January 2010). CEPR Discussion Paper No. DP7624, Available at SSRN: https://ssrn.com/abstract=1536383

Christopher J. Erceg (Contact Author)

Board of Governors of the Federal Reserve System ( email )

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Jesper Linde

Sveriges Riksbank - Research Division ( email )

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