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The Optimal Composition of Public Spending in a Deep Recession

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

Cahiers de Recherches Economiques du Département d'économie from Université de Lausanne, Faculté des HEC, Département d’économie

Abstract: We study optimal monetary and fiscal policy under commitment in an economy where monetary policy is constrained by the zero lower bound on the nominal interest rate, and where the government can allocate spending to public consumption and public investment. We show that the optimal response to an adverse shock that precipitates the economy into a liquidity trap entails a small and short-lived increase in public consumption but a large and persistent increase in public investment, which lasts well after the natural rate of interest has ceased to be negative. During this period, the optimal composition of public spending is therefore heavily skewed towards public investment. Contrary to the literature that abstracts from public investment, we find that the optimal increase in total public spending in a deep recession is sizable. However, we show that this fiscal expansion has little to do with a stabilization motive and is instead warranted by the intertemporal allocation of resources that efficiency dictates even in the absence of an output gap.

Keywords: Public spending; Public investment; Time to build; Ramsey policies; Zero lower bound (search for similar items in EconPapers)
JEL-codes: E4 E52 E62 H54 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge and nep-mac
Date: 2016-04
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Persistent link: https://EconPapers.repec.org/RePEc:lau:crdeep:16.09

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