DP7624 Is There a Fiscal Free Lunch in a Liquidity Trap?

Author(s): Christopher Erceg , Jesper Lindé

Publication Date: January 2010

Keyword(s): DSGE Model , Fiscal Policy , Liquidity Trap , Monetary Policy , Zero Bound Constraint

JEL(s): E52 , E58

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP7624.asp

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.