Fiscal Stabilization Policy Outside of the Zero Lower Bound

This paper revisits the traditional hierarchy of macroeconomic stabilization tools outside of the zero lower bound. In the benchmark New-Keynesian model monetary policy is always preferred to fiscal policy because fiscal policy has relative costs without delivering any relative benefits. I explore the robustness of this standard “monetary supremacy” result in three steps. First, motivated by empirical work documenting large marginal propensities to consume out of predictable income changes, I introduce hand-to-mouth consumers into the benchmark model. Such non-optimizing agents amplify the stimulative effects of tax and spending changes. However, I find that even in a model with large fiscal multipliers, there remains no role for fiscal policy outside of the zero lower bound. Although fiscal policy is potent in this scenario, it nevertheless diverts real resources, while monetary policy remains able to implement the first best allocation without imposing any economic distortions. Second, I explore four other environments where fiscal policy has benefits relative to monetary policy. These include introducing uncertainty about the effectiveness of monetary and fiscal policy (appealing to the logic that it is better to use two tools with independent errors than only one tool alone), adding adjustment costs to give monetary policy a longer implementation lag than fiscal policy (matching the data on impulse responses to policy shocks), introducing heterogeneous agents with varying welfare weights (recognizing that fiscal policy can more easily target assistance), and allowing for fiscal policy to act as a signaling mechanism in a game of incomplete information and coordination failures. Finally, I turn to the question of relative costs, appealing to the finance literature which argues that low interest rates may instigate or propagate asset bubbles, promote maturity mismatch and excessive leverage, and redistribute across agents. I propose a path for examining optimal countercyclical policy in environments where monetary policy might be forced to trade off gains in price stability and full employment against the potential costs of financial instability.