How do financial frictions a¤ect the spending multiplier during a liquidity trap?

Julio Carrillo () and Céline Poilly ()
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Julio Carrillo: Banco de México
Céline Poilly: AMSE - Aix-Marseille Sciences Economiques - EHESS - École des hautes études en sciences sociales - AMU - Aix Marseille Université - ECM - École Centrale de Marseille - CNRS - Centre National de la Recherche Scientifique

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Abstract: We show that credit market imperfections substantially increase the government-spending multiplier when the economy enters a liquidity trap. This finding is explained by the tight association between capital goods and firms' collateral, a relationship that we highlight as the capital-accumulation channel. During a liquidity trap, a government spending expansion reduces the real interest rate, leading to a period of cheap credit. Entrepreneurs use this time to accumulate capital, which persistently improves their balance sheets and reduces their future costs of credit. A public spending expansion can thus encourage private investment, yielding consequently a large spending multiplier. This effect is further reinforced by Fisher's debt-deflation channel.

Keywords: Financial Frictions; Zero Lower Bound (search for similar items in EconPapers)
Date: 2013-01-31
Note: View the original document on HAL open archive server: https://hal.science/hal-05468935v1
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Citations: View citations in EconPapers (1)

Published in Review of Economic Dynamics, 2013, 16, pp.296-311

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