Working Paper: NBER ID: w18381
Authors: Emmanuel Farhi; Iván Werning
Abstract: We provide explicit solutions for government spending multipliers during a liquidity trap and within a fixed exchange regime using standard closed and open-economy models. We confirm the potential for large multipliers during liquidity traps. For a currency union, we show that self-financed multipliers are small, always below unity. However, outside transfers or windfalls can generate larger responses in out- put, whether or not they are spent by the government. Our solutions are relevant for local and national multipliers, providing insight into the economic mechanisms at work as well as the testable implications of these models.
Keywords: Fiscal multipliers; Liquidity traps; Currency unions
JEL Codes: E52; E62; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Government spending in a liquidity trap (E62) | Large multipliers for output (C39) |
| Government spending (H59) | Stimulates inflation (E31) |
| Stimulates inflation (E31) | Lowers real interest rates (E43) |
| Lowers real interest rates (E43) | Boosts current spending (E62) |
| Boosts current spending (E62) | Feedback loop increases consumption (D19) |
| Feedback loop increases consumption (D19) | Reinforces initial effect of government spending (E62) |
| Government spending in a currency union (H69) | Diminished effectiveness (I12) |
| Loss of competitiveness due to inflation (E31) | Depresses private spending (E62) |
| Outside transfers linked to government spending (H59) | Enhance multipliers (C39) |