Fiscal policy in the Great Recession

Abstract

This thesis investigates three questions on fiscal policy that have gained importance in the recent turbulent times of general economic decline, labelled as the Great Recession. The first chapter examines how government spending multipliers can vary depending on the location of the debt holder. Empirically, we find that fiscal multipliers are larger when government purchases are financed by issuing debt to non-resident foreign investors, than to resident home investors. Using a theoretical model we then show how the location of the government debt holder produces these di?erential responses through the extent that investment is crowded out in each case. Increasing international capital mobility of the resident private sector can attenuate the di?erence between the two types of financing. The second chapter contributes to the current debate on fiscal sustainability and fiscal coordination in currency unions. It does so using a large-scale New-Keynesian DSGE model calibrated to the EA South and EA North, and fed with a particular fiscal policy scenario identified using the guidelines of the Stability and Growth Pact. The results suggest that when monetary policy is constrained by the zero-lower bound an expansion in the EA North o?sets a consolidation in the EA South leading to a union-wide increase in output. The third chapter studies the effects of fiscal policy in a setting where crisis shocks propagate through the real exchange rate to generate distortions in labour and financial markets. The joint presence of labour market and financial frictions, modelled as downward nominal rigid wages and a collateral constraint on private borrowing, endogenously generate unemployment and persistently high debt levels. Fiscal policies aiming to stimulate or consolidate the economy affect the movement of the real exchange rate in such a way so as to generate it toothless in the face of a 'debt-unemployment' trade-off.