The optimal composition of public spending in a deep recession

Hafedh Bouakez, Michel Guillard () and Jordan Roulleau-Pasdeloup

Journal of Monetary Economics, 2020, vol. 114, issue C, 334-349

Abstract: We study optimal fiscal policy in an economy plunged into a deep recession characterized by a liquidity trap, and in which the government can allocate spending both to consumption and investment goods. Public investment increases the stock of public capital subject to a time-to-build constraint. The zero lower bound on the nominal interest rate binds as a result of a large shock that increases households’ desire to save in the risk-free asset, pushing the natural rate of interest below zero. Under nominal rigidities and sub-optimal monetary policy, the shock leads to a large decline in private consumption and investment. We show that the optimal response to such a shock is to temporarily raise public spending above the level that would be dictated by classical principles, and to tilt its composition towards public investment. This compositional shift lasts well after the natural rate has ceased to be negative. Our results suggest that the American Recovery and Reinvestment Act of 2009 was insufficiently oriented towards public investment.

Keywords: Public consumption; Public investment; Optimal fiscal policy; Time to build; Zero lower bound (search for similar items in EconPapers)
JEL-codes: E4 E52 E62 H54 (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (10)

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Related works:
Working Paper: The Optimal Composition of Public Spending in a Deep Recession (2016)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:moneco:v:114:y:2020:i:c:p:334-349

DOI: 10.1016/j.jmoneco.2019.03.006

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