Fiscal Stimulus of Last Resort

TL;DR

This paper analyzes how fiscal policy can help escape liquidity traps in a monetary model with finite-horizon agents and interest rate bounds, highlighting the conditions under which fiscal stimulus is effective or destabilizing.

Contribution

It demonstrates that sustainable fiscal policies can escape liquidity traps, while overly aggressive stimulus may cause global indeterminacy and economic instability.

Findings

Activist fiscal policies can lead to stable inflation paths.

Debt targeting can worsen liquidity trap dynamics.

Overly aggressive stimulus causes spiral dynamics and indeterminacy.

Abstract

I examine global dynamics in a monetary model with overlapping generations of finite-horizon agents and a binding lower bound on nominal interest rates. Debt targeting rules exacerbate the possibility of self-fulfilling liquidity traps, for agents expect austerity following deflationary slumps. Conversely, activist but sustainable fiscal policy regimes - implementing intertemporally balanced tax cuts and/or transfer increases in response to disinflationary trajectories - are capable of escaping liquidity traps and embarking inflation into a globally stable path that converges to the target. Should fiscal stimulus of last resort be overly aggressive, however, spiral dynamics around the liquidity-trap steady state exist, causing global indeterminacy.