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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page Is There a Fiscal Free Lunch in a Liquidity Trap?
Christopher J. Erceg and Jesper Linde
2010-1003  (July 2010, latest version August 2012)

Abstract:  This paper uses a DSGE model to examine the effects of an expansion in government spending in a liquidity trap. If the liquidity trap is very prolonged, the spending multiplier can be much larger than in normal circumstances, and the budgetary costs minimal. But given this "fiscal free lunch," it is unclear why policymakers would want to limit the size of fiscal expansion. Our paper addresses this question in a model environment in which the duration of the liquidity trap is determined endogenously, and depends on the size of the fiscal stimulus. We show that even if the multiplier is high for small increases in government spending, it may decrease substantially at higher spending levels; thus, it is crucial to distinguish between the marginal and average responses of output and government debt.

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Monetary policy, fiscal policy, liquidity trap, zero bound constraint, DSGE model

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Last update: October 10, 2012