Liquidity Trap, Private Behavior Preference and The Micro-Foundation of Fiscal Multiplier Dynamics

Abstract

Liquidity trap and private behavior preference of micro-agents are important for macroeconomic policy decisions, thereby this paper examines the fiscal multiplier dynamics through incorporating consumer habit formation and investor confidence in a new Keynesian dynamic stochastic general equilibrium model, which deepens our understanding of the micro-foundation of fiscal multiplier. Especially, considering that the US monetary policy faced zero lower bound after the subprime crisis, this paper further identifies how the liquidity trap affects fiscal multipliers. The results indicate that the effects of liquidity trap on fiscal policy are determined by the trade-off between interest rate transmission effect and precautionary savings effect. The existence of habit formation amplifies the fiscal multiplies of two types of government spending, while weakening the policy effect of labor tax and consumption tax, and barely affecting the output effect of capital tax. The investor confidence channel amplifies fiscal multipliers as a whole in the medium and long term, while presents a weak initial effect as a result of suffering a lag in capital accumulation. In addition, contrary to habit formation, investor confidence channel can slightly amplify the expansionary effect of liquidity trap on multipliers. This study provides policy implications for how to improve the fiscal multiplier in a liquidity trap or with micro-foundation changes.

Keywords: Liquidity trap, Habit formation, investor confidence, Fiscal multiplier