Fiscal Policy in a Depressed Economy

This paper examines logic and evidence bearing on the efficacy of fiscal policy in severely depressed economies. In normal times central banks offset the effects of fiscal policy. This keeps the policy-relevant multiplier near zero. It leaves no space for expansionary fiscal policy as a stabilization policy tool. But when interest rates are constrained by the zero nominal lower bound, discretionary fiscal policy can be highly efficacious as a stabilization policy tool. Indeed, under what we defend as plausible assumptions of temporary expansionary fiscal policies may well reduce long-run debt-financing burdens. These conclusions derive from even modest assumptions about impact multiplier, hysteresis effects, the negative impact of expansionary fiscal policy on real interest rates, and from recognition of the impact of interest rates below growth rates on the evolution of debt-GDP ratios. While our analysis underscores the importance of governments pursuing sustainable long run fiscal policies, it suggests the need for considerable caution regarding the pace of fiscal consolidation in depressed economies where interest rates are constrained by a zero lower bound. 1 We would like to thank the Coleman Fung Center for Risk Management at U.C. Berkeley and the Berkeley Freshman Seminar Program for financial support. We would like to thank Simon Galle and Charles Smith for excellent research assistance. And we would like to thank Alan Auerbach, Laurence Ball, Robert Barsky, Raj Chetty, Gabriel Chodorow-Reich, Jan Eberly, Barry Eichengreen, Justin Fox, James K. Galbraith, Yurii Gorodnichenko, Bob Hall, Jan Hatzius, Bart Hobijn, Greg Ip, Miles Kimball, Brock Mendel, John Mondragon, Peter Orszag, Christina Romer, David Romer, Jesse Rothstein, Matthew Shapiro, Robert Waldmann, Johannes Wieland, Jim Wilcox, and especially Justin Wolfers for helpful comments and discussions.