PRELIMINARY AND INCOMPLETE DRAFT!

This paper explores the effects of real government spending in a New Keynesian model. A social welfare criterion is derived by a second order Taylor expansion of the representative house-hold utility. The welfare criterion includes inflation, output gap and the deviation of government spending from a time varying target level. Using this welfare criterion, optimal monetary and fiscal policy are analyzed. This paper shows that even if Ricardian Equivalence holds, real spend-ing can have substantial effects on output and prices. This is particularly relevant in a liquidity trap since then the effectiveness of monetary policy is reduced by the zero bound. The only way the government can use monetary policy in a liquidity trap to influence aggregate demand is by committing to future monetary actions that are dynamically inconsistent. On the other hand, increasing real government spending involves current action and is thus not subject to the same credibility problem. For a government that cannot credibly commit to future policies, varying real government spending is therefore a particularly effective policy tool in a liquidity trap. Note: Apart from minor revisions, this draft was written in October 2000. The paper will be revised an reorganized since many of the issues in this paper also arise in “Committing to being irresponsible: Deficit Spending to Escape a Liquidity Trap ” although in the context of a different model. 1