TAILIEUCHUNG - Federal Reserve Bank of New York Staff Reports: What Fiscal Policy Is Effective at Zero Interest Rates?

The run-up to the 2008 global nancial crisis was characterised by an environment of low interest rates and a rapid increase in housing market activity across OECD countries. Some scholars argue that expansionary monetary policy has been signi cantly responsible for the low level of interest rates and the subsequent house price boom. Others contend that a scarcity of nancial assets led to capital in ows to developed economies, depressing long rates in government bond markets and stimulating an increase in demand for housing. A third school of thought maintains that excessive mispricing of risk associated with nancial innovation has led to a misallocation of capital to the real. | Federal Reserve Bank of New York Staff Reports What Fiscal Policy Is Effective at Zero Interest Rates Gauti B. Eggertsson Staff Report no. 402 November 2009 This paper presents preliminary findings and is being distributed to economists and other interested readers solely to stimulate discussion and elicit comments. The views expressed in the paper are those of the author and are not necessarily reflective of views at the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author. What Fiscal Policy Is Effective at Zero Interest Rates Gauti B. Eggertsson Federal Reserve Bank of New York Staff Reports no. 402 November 2009 JEL classification E52 Abstract Tax cuts can deepen a recession if the short-term nominal interest rate is zero according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures. Another example is a cut in capital taxes. This tax cut deepens a recession because it encourages people to save instead of spend at a time when more spending is needed. Fiscal policies aimed directly at stimulating aggregate demand work better. These policies include 1 a temporary increase in government spending and 2 tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply such as an investment tax credit or a cut in sales taxes. The results are specific to an environment in which the interest rate is close to zero as observed in large parts of the world today. Key words tax and spending multipliers zero interest rates deflation Eggertsson Federal Reserve Bank of New York e-mail . This paper is a work in progress in preparation for the NBER Macroeconomics Annual 2010. A previous draft was circulated in December 2008 under the title Can Tax Cuts Deepen the Recession The author thanks Matthew Denes for .

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