The Fiscal Multiplier in a Liquidity‐Constrained New Keynesian Economy

• DOI: http://doi.org/10.1111/sjoe.12208
• Published date: 01 January 2018
• Date: 01 January 2018

©The editors of The Scandinavian Journal of Economics 2016.

Scand. J. of Economics 120(1), 93–123, 2018

DOI: 10.1111/sjoe.12208

The Fiscal Multiplier in a Liquidity-

Constrained New Keynesian Economy*

Engin Kara

Cardiff University, Cardiff CF10 3EU, UK

karaengin@gmail.com

Jasmin Sin

International Monetary Fund, Washington DC 20431, USA

jsin@imf.org

Abstract

We study the effects of fiscal policy on the macroeconomy using a liquidity-constrained

New Keynesian model in which government bonds are liquid, and private financial

assets are only partially liquid. We find that the fiscal multipliers in this economic

environment are large enough for fiscal policy to be highly effective. In this model,

a bond-financed fiscal expansion can stimulate output because higher public borrowing

improves liquidity by increasing the proportion of liquid assets in private-sector wealth.

Keywords: Credit constraints; DSGE models; fiscal policy; liquidity trap; monetary policy

JEL classification:E32; E52; E58; E62

I. Introduction

Over the last decade, in many if not all developed countries, monetary

policy has been the main instrument for managing the growth of aggregate

demand and inflationary pressure. The chief monetary policy tool has been

short-term interest rates. The response to the recent financial crisis has

typically been to lower the nominal interest rate to its zero lower bound

(ZLB). As monetary policy loses its power at the ZLB, the conventional

option of cutting interest rates is no longer available. This raises the

question of whether fiscal policy is effective in mitigating the effects of

the crisis.

Answering this question requires a model that can capture the key

aspects of the crisis. As many noted, the realization at the onset of

*We thank two anonymous referees for insightful comments. We also thank Edmund Cannon,

Jon Temple, James Cloyne, Michael McMahon, and seminar participants at the Bank of

England, University of Bath, University of Bristol, the 45thAnnual Money Macro and Finance

Conference, and the RES Easter School 2013 for helpful comments. The views expressed in

this paper are those of the authors and do not necessarily represent the views of the IMF, its

Executive Board, or IMF management.

94 Fiscal multiplier in a liquidity-constrained New Keynesian economy

the crisis that many private financial assets were of lower quality – and

therefore accompanied by higher default risks than previously assumed –

led to a flight to liquid assets. At the height of the crisis, the markets

for private financial assets essentially froze. The drop in the resaleability

of private assets diminished the ability of firms both to raise funds and

to use their assets as collateral for borrowing. The consequent decrease

in investment led to substantial drops in output and inflation. To combat

the recession, central banks lowered the nominal interest rate to its ZLB,

generating a liquidity trap.

In this paper, we study the effectiveness of fiscal policy using the model

proposed by Del Negro et al. (2011) (henceforth DEFK). This model

reformulates the state-of-the-art version of New Keynesian economics, as

in Christiano et al. (2005) (henceforth CEE) and Smets and Wouters (2007)

(henceforth SW), by incorporating the liquidity frictions as described in

Kiyotaki and Moore (2012) (henceforth KM). In the DEFK model, the

economy is populated with a large number of identical households. Each

household can save in two types of financial assets: government bonds and

private equity. Government bonds are liquid, while private assets are not.1

During each period, a randomly chosen fraction of household members

becomes entrepreneurs. Entrepreneurs have the opportunity to invest in

new capital, which gives a better return than government bonds or private

equity. Although investment opportunities are attractive, entrepreneurs are

liquidity constrained: entrepreneurs can borrow by issuing new equity,

but the amount that they can issue in each period is limited; private

equity is illiquid, so entrepreneurs can sell only up to a certain portion

of their equity holdings in each period. The rest of the household members

are workers. They do not have the opportunity to invest in new capital,

and they are not liquidity constrained. They work, consume, and save by

holding government bonds and private equity. Other features of the model

are standard New Keynesian. Firms and workers enjoy some degree of

monopoly power; prices and wages remain unchanged, on average, for

several months. The central bank sets the interest rate following a Taylor-

style rule. The presence of liquidity frictions in the DEFK model allows

us to simulate the recent financial crisis. Comparison of the empirical

data and the model’s projections shows that the DEFK model performs

well in explaining the responses of the key macroeconomic variables to

the recent crisis.2

1As noted by DEFK, private equity has a broad definition in this model. It can be interpreted

as privately issued paper such as commercial paper, bank loans, mortgages, and so on.

2DEFK use their model to examine the effectiveness of quantitative easing, and they find it

to be an effective policy. Ajello (2016), Driffill and Miller (2013), and Shi (2015) also use

the DEFK/KM framework to study the current financial crisis.

©The editors of The Scandinavian Journal of Economics 2016.