Government Spending Multiplier, Liquidity Trap and Deleveraging

The most recent Global recession forced several central banks to lower their short term nominal interest rates to zero. The monetary policy is faced with the zero lower bound where the interest rates cannot be further decreased. In this situation, the monetary policy is impotent to stimulate the economy. The fiscal policy has become more important in context of Global recession. The persistent effects of the Global recession can be partly explained with a debt overhang. The Global recession was preceded with a period of debt leveraging and followed with a period of reducing the amount of debt in the economy. This process of debt reduction is called deleveraging. The aim of this thesis is to analyse the fiscal policy effectiveness in liquidity trap that is induced by deleveraging. This thesis analyses the effects that an expansion in government purchases has on output in liquidity trap economy. This analysis can be interpreted as an evaluation on the effectiveness of fiscal policy to stimulate the economy. This thesis is going to study the size of this effect with government spending multiplier. This thesis is partly conducted as literature review. Firstly, this thesis analyses the size of the government spending multiplier in different models and under different economic assumptions. Secondly, this paper presents a model that is based on a specific paper. Based on the paper in question, this thesis discusses the effectiveness of fiscal stimulus in deleveraging induced liquidity trap environment. Based on the specific model, this thesis presents the factors affecting the size of its government spending. From my own analysis on this specific model, I find additional factors that affect the government spending multiplier. The specific model used in this thesis relies on a heterogenous household framework with sticky prices. The model economy is faced with a shock that reduces the debt limit. This limit controls the amount of borrowing in the economy. There are two types of households in this model. The patient households smooth their consumption over the periods and the more impatient households consume their entire income and borrow up to the debt limit. The shock forces more impatient households to pay back their debt and lower their consumption. The central bank can stimulate the demand of the patient households if the nominal interest rates are positive. If the shock is large enough the nominal interest rates cannot compensate the decreased demand. When the nominal interest rates are in the lower bound, the economy is in liquidity trap. The liquidity trap can be characterized as zero lower bound equilibrium with decreased output and negative inflation. Based on this specific model, this paper finds that when the monetary policy in constrained by the zero lower bound on nominal interest rates the effectiveness of fiscal policy will be increased. Furthermore based on the same model, this thesis finds that the fiscal policy is more effective in liquidity trap when part of the households is constrained by the borrowing and liquidity constraints. This paper argues that the government spending increase is an effective tool to stimulate economy in liquidity trap that is a result of a large enough deleveraging shock. In this thesis, the effectiveness of fiscal stimulus in liquidity trap is analysed with log-linearised model. Based on literature review this thesis discusses that even though the linearisation simplifies the model analysation it can also produce misleading policy implications. Therefore, the implications of the used linearisation method can be argued to produce too optimistic views on government spending multiplier