The Government Spending Multiplier in a Deep Recession

Jordan Roulleau-Pasdeloup

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

Abstract: The usual mechanism through which government spending can be effective in increasing GDP in a liquidity trap emphasizes the role of aggregate demand. Higher government spending generates a lower expected real interest rate through a higher real wage, which translates into higher inflation. This lower real rate increases aggregate demand. I present new evidence that casts doubt on the empirical relevance of this mechanism. In particular,liquidity traps occur exclusively in recessions, which appear to be situations where higher government spending generates less inflation than in expansion times. To rationalize this, I build a New Keynesian model with search and matching frictions in the labor market and a downward rigid nominal wage. When solved using global methods, this model generates asymmetric fluctuations of recruiting costs along the business cycle. This permits the model to generate (i) a higher government spending multiplier in recessions versus expansions and (ii) a significantly higher multiplier at the zero lower bound without relying on a counterfactually large reaction of wages and inflation, both of which are in line with empirical evidence. Decomposing the contributions of recession versus liquidity trap dynamics, I find that the latter accounts for less than half of the additional multiplier effect at the Zero Lower Bound.

Keywords: Zero lower bound; New Keynesian; Government spending multiplier; Search and Matching Frictions (search for similar items in EconPapers)
JEL-codes: E24 E31 E32 E52 E62 (search for similar items in EconPapers)
Pages: 58 pp.
Date: 2016-11
New Economics Papers: this item is included in nep-dge and nep-mac
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (12)

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Persistent link: https://EconPapers.repec.org/RePEc:lau:crdeep:16.22

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