Policy Multipliers Under an Interest Rate Peg of Deterministic Versus Stochastic Duration

23 Pages Posted: 17 Jun 2013

See all articles by Charles T. Carlstrom

Charles T. Carlstrom

Federal Reserve Bank of Cleveland

Timothy S. Fuerst

University of Notre Dame

Matthias Paustian

Bank of England

Date Written: June 2013

Abstract

This paper revisits the size of the fiscal multiplier. The experiment is a fiscal expansion under the assumption of a pegged nominal rate of interest in linearised sticky price model. We demonstrate that a quantitatively important issue is the articulation of the exit from the policy experiment. If the monetary-fiscal expansion is stochastic with a mean duration of T periods, the fiscal multiplier can be unboundedly large. However, if the monetary-fiscal expansion is for fixed T periods, the multiplier is much smaller. Our explanation rests on a Jensen’s inequality-type argument: the deterministic multiplier is convex in duration, and the stochastic multiplier is a weighted average of the deterministic multipliers. The quantitative difference in the two multipliers also arises in a model with capital, and in the baseline non-linear model. However, the difference between the two is less pronounced in the non-linear models. The errors from a linear approximation are much larger for the stochastic exit model than for the deterministic exit model. Thus, we conclude that the deterministic exit model should be preferred.

Keywords: Fiscal multiplier, fixed interest rates, New Keynesian model, zero lower bound

JEL Classification: E32

Suggested Citation

Carlstrom, Charles T. and Fuerst, Timothy S. and Paustian, Matthias, Policy Multipliers Under an Interest Rate Peg of Deterministic Versus Stochastic Duration (June 2013). Bank of England Working Paper No. 475, Available at SSRN: https://ssrn.com/abstract=2280315 or http://dx.doi.org/10.2139/ssrn.2280315

Charles T. Carlstrom

Federal Reserve Bank of Cleveland ( email )

PO Box 6387
Cleveland, OH 44101-1387
United States
216-579-2294 (Phone)
216-579-3050 (Fax)

Timothy S. Fuerst

University of Notre Dame ( email )

Notre Dame, IN 46556
United States

Matthias Paustian (Contact Author)

Bank of England ( email )

Threadneedle Street
London, EC2R 8AH
United Kingdom

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