Fiscal Multipliers: Liquidity Traps and Currency Unions

Emmanuel Farhi and Iván Werning

Working Paper from Harvard University OpenScholar

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 New Keynesian 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, unless the accompanying tax adjustments involve substantial static redistribution from low to high marginal propensity to consume agents, or dynamic redistribu- tion from future to present non-Ricardian agents. But outside-financed multipliers which require no domestic tax adjustment can be large, especially when the average marginal propensity to consume on domestic goods is high or when government spending shocks are very persistent. 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.

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Working Paper: Fiscal Multipliers: Liquidity Traps and Currency Unions (2012)
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