DP11577 | The Optimal Use of Government Purchases for Stabilization

Publication Date

10/18/2016

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Abstract

This paper explores how government purchases can improve stabilization. When unemployment is inefficiently high, optimal government purchases deviate from the Samuelson level to reduce the unemployment gap. Hence, stimulus spending is desirable in slumps whenever the unemployment multiplier is positive. Then, the optimal level of stimulus spending is increasing in the multiplier for small multipliers, largest for a moderate multiplier, and decreasing beyond that. Furthermore, the optimal level of stimulus spending is increasing in the elasticity of substitution between public and private consumption. In particular, optimal stimulus spending is zero when extra public services are useless, and it completely fills the unemployment gap when extra public services are as valuable as extra private services. The results hold whether taxes are nondistortionary or distortionary.