Working Paper: NBER ID: w29134
Authors: Riccardo Bianchi Vimercati; Martin S. Eichenbaum; Joao Guerreiro
Abstract: This paper addresses the question: how sensitive is the power of fiscal policy at the ZLB to the assumption of rational expectations? We do so through the lens of a standard NK model in which people are dynamic-level-k thinkers. Our analysis weakens the case for using government spending to stabilize the economy when the ZLB binds. The less sophisticated people are, the smaller the government-spending multiplier is. Our analysis strengthens the case for using tax policy to stabilize output when the ZLB is binding. The power of tax policy to stabilize the economy during the ZLB period is essentially undiminished when agents do not have rational expectations. Our results are robust to whether or not Ricardian equivalence holds. Finally, we show that the way in which tax policy is communicated is critical to its effectiveness.
Keywords: Fiscal Policy; Zero Lower Bound; Rational Expectations; Tax Policy; Government Spending
JEL Codes: E0; E32; E62
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| lower cognitive sophistication (D91) | smaller government spending multiplier (E62) |
| well-communicated tax policies (H26) | stabilize the economy (E63) |
| failure of Ricardian equivalence (H39) | government debt influences aggregate demand (H63) |