DP9992 | Fiscal Policy in an Unemployment Crisis

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25/05/2014

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Abstract

This paper shows that large fiscal multipliers arise naturally from equilibrium unemployment dynamics. In response to a shock that brings the economy into a liquidity trap, an expansion in government spending increases output and causes a fall in the unemployment rate. Since movements in unemployment are persistent, the effects of current spending linger into the future, leading to an enduring rise in income. As an enduring rise in income boosts private demand, even a temporary increase in government spending sets in motion a virtuous employment-spending spiral with a large associated multiplier. This transmission mechanism contrasts with the conventional view in which fiscal policy may be efficacious only under a prolonged and committed rise in government spending, which engineers a spiral of increasing inflation.