State Dependence of Fiscal Multipliers: The Source of Fluctuations Matters

108 Pages Posted: 27 Feb 2021

See all articles by Mishel Ghassibe

Mishel Ghassibe

University of Oxford - Department of Economics

Francesco Zanetti

University of Oxford

Date Written: December 13, 2020

Abstract

We develop a general theory of state-dependent fiscal multipliers in a framework featuring interaction between two empirically relevant goods market frictions: idle productive capacity and unsatisfied demand. Our key novel finding is that the source of economic fluctuations determines the cyclicality of fiscal multipliers. Policies that stimulate aggregate demand, such as government spending and consumption tax cuts, have multipliers that are large in demand driven recessions, but small and possibly negative in supply-driven downturns. On the other hand, policies that boost aggregate supply, such as cuts in taxes on labor income and firms’ payroll and sales, are ineffective in demand driven recessions, but powerful if the downturn is driven by supply factors. Spending austerity, implemented by a reduction in government consumption, can be the policy with the largest multiplier in severe supply-side recessions and demand-driven booms, provided elasticities of labor demand and supply are sufficiently low. We obtain modelfree empirical support for our theoretical predictions by using a novel econometric specification that allows us to estimate spending and tax cut multipliers in recessionary and expansionary episodes, conditional on those being either demand- or supply-driven.

Keywords: business cycle, fiscal multipliers, state dependence, search-and-matching in the goods market.

JEL Classification: E32, E62, J64.

Suggested Citation

Ghassibe, Mishel and Zanetti, Francesco, State Dependence of Fiscal Multipliers: The Source of Fluctuations Matters (December 13, 2020). Available at SSRN: https://ssrn.com/abstract=3756128 or http://dx.doi.org/10.2139/ssrn.3756128

Mishel Ghassibe (Contact Author)

University of Oxford - Department of Economics ( email )

10 Manor Rd
Oxford, OX1 3UQ
United Kingdom

HOME PAGE: http://https://sites.google.com/view/mishel-ghassibe

Francesco Zanetti

University of Oxford ( email )

Mansfield Road
Oxford, Oxfordshire OX1 4AU
United Kingdom

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