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Animal Spirits and Fiscal Policy

Paul De Grauwe and Pasquale Foresti ()

Journal of Economic Behavior & Organization, 2020, vol. 171, issue C, 247-263

Abstract: In this paper, we study the effects of government spending with a behavioral macroeconomic model in which agents have limited cognitive capabilities and use simple heuristics to form their expectations. However, thanks to a learning mechanism, agents can revise their forecasting rule according to its performance. This feature produces endogenous and self-fulfilling waves of optimistic and pessimistic beliefs (animal spirits). This framework allows us to show that the short-run spending multiplier is state dependent. The multiplier is stronger under either extreme optimism or pessimism and reduces in periods of tranquility. Furthermore, the more the central bank focuses on output gap stabilization, the smaller the multiplier. We also show that periods of increasing public debt are characterized by intense pessimism, while intense optimism occurs in periods of decreasing debt. This allows us to show that governments face a trade-off between the stabilization of the animal spirits and the stabilization of public debt. Then, we show that the existence of this trade-off has implications also for the stabilization of the output gap.

Keywords: Fiscal policy; Spending multiplier; Behavioral DSGE model; Animal spirits; Public debt; Policy state-dependent effects (search for similar items in EconPapers)
JEL-codes: E10 E32 E62 E71 D83 (search for similar items in EconPapers)
Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jeborg:v:171:y:2020:i:c:p:247-263

DOI: 10.1016/j.jebo.2020.01.015

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