What fiscal policy is effective at zero interest rates?

Gauti Eggertsson

No 402, Staff Reports from Federal Reserve Bank of New York

Abstract: Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures. Another example is a cut in capital taxes. This tax cut deepens a recession because it encourages people to save instead of spend at a time when more spending is needed. Fiscal policies aimed directly at stimulating aggregate demand work better. These policies include 1) a temporary increase in government spending; and 2) tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply, such as an investment tax credit or a cut in sales taxes. The results are specific to an environment in which the interest rate is close to zero, as observed in large parts of the world today.

Keywords: Fiscal policy; Interest rates; Taxation; Government spending policy (search for similar items in EconPapers)
Date: 2009
New Economics Papers: this item is included in nep-cba, nep-mac, nep-pbe and nep-pub
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Chapter: What Fiscal Policy Is Effective at Zero Interest Rates? (2011)
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