Recent Research

Abstract 

We study optimal fiscal policy in an economy plunged into a deep recession character- ized 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.
JEL classification: E4, E52, E62, H54

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Abstract 

The Fiscal Theory of the Price Level (FTPL) establishes that the general level of prices is determined at equilibrium in order to satisfy the intertemporal government budget constraint. Importantly, in a representative agent framework, this theory re- quires that the present value of future primary surpluses has to be strictly positive. In a richer framework where the economy is non-Ricardian—an overlapping genera- tions of infinitely-lived agents model—and where the monetary policy is constrained by the Zero Lower Bound (ZLB) on nominal interest rates, we show that the FTPL case arises endogenously, even when exogenous primary surpluses are null. In such a framework, a bubble-like component of government debt induces the price level determinacy by the fiscal policy and affects its equilibrium level.

Keywords: Wealth Effects, Liquidity Trap, Deflation, Zero Lower Bound, Fiscal The- ory of the Price Level, Monetary and Fiscal Rules, Public Debt.
JEL classification: E63, E52.

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Abstract

We study the effectiveness of public investment in stimulating an economy stuck in a liquidity trap. We do so in the context of a tractable new-Keynesian economy in which a fraction of government spending increases the stock of public capital subject to a time-to-build constraint. Public investment projects typically entail significant time-to-build delays, which often span several years from approval to completion. We show that this feature implies that the spending multiplier associated with public investment can be substantially large — nearly twice as large as the multiplier associated with public consumption — in a liquidity trap. Intuitively, when the time to build is sufficiently long, and to the extent that public capital raises the marginal productivity of private inputs, the resulting disinflationary effect will occur after the economy has escaped from the liquidity trap. At the same time, the increase in households' expected wealth amplifies aggregate demand while the economy is still in the liquidity trap. Using a medium-scale model extended to allow for the accumulation of public capital, we quantify the multiplier associated with the spending component of the 2009's ARRA, which allocated roughly 40% of the authorized funds to public investment. We find a peak multiplier of 2.31. Our results also indicate that failing to account for the composition of the stimulus by overlooking its investment component would lead one to underestimate the spending multiplier by about 50%.

Keywords: Public spending; Public investment; Time to build; Multiplier; Zero lower bound
JEL classification: E4, E52, E62, H54

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