Fiscal Policies in Booms and Busts

40 Pages Posted: 22 May 2019

See all articles by Paul De Grauwe

Paul De Grauwe

London School of Economics & Political Science (LSE); CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Centre for Economic Policy Research (CEPR)

Pasquale Foresti

University of Roehampton

Yuemei Ji

University College London - School of Slavonic and East European Studies

Date Written: May 2019

Abstract

We introduce fiscal policies into a behavioral macroeconomic model. We show how animal spirits play an important role in the dynamics of the business cycle and of public debt. These animal spirits are able to generate different sizes of fiscal multipliers depending on the state of the economy. Depending on the interest rate regime (high or low), they affect the capacity of fiscal authorities to stabilize the economy. In the high interest rate regime the fiscal authorities face a steep trade-off between output stabilization and the stabilization of public debt, i.e. attempts to stabilize the business cycle quickly hit a limitation of debt sustainability. In the low interest rate regime, when the steady state interest rate is lower than the growth rate of the economy, the use of fiscal policy as a tool of output stabilization is made considerably stronger.

Keywords: Fiscal Multiplier, Fiscal policy, low and high interest rate regimes, public debt sustainability, tradeoffs

Suggested Citation

De Grauwe, Paul and Foresti, Pasquale and Ji, Yuemei, Fiscal Policies in Booms and Busts (May 2019). CEPR Discussion Paper No. DP13740. Available at SSRN: https://ssrn.com/abstract=3391087

Paul De Grauwe (Contact Author)

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, DE-81679
Germany

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Pasquale Foresti

University of Roehampton ( email )

Roehampton Lane
London, SW15 5PU
United Kingdom

Yuemei Ji

University College London - School of Slavonic and East European Studies ( email )

Malet Street
London WC1E 7HU
United Kingdom

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