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THE GOVERNMENT SPENDING MULTIPLIER IN A MODEL WITH THE COST CHANNEL

Published online by Cambridge University Press:  14 April 2020

Salem Abo-Zaid
Salem Abo-Zaid*
Affiliation:
University of Maryland-Baltimore County
*
Address correspondence to: Salem Abo-Zaid, Department of Economics, University of Maryland-Baltimore County, 1000 Hilltop Circle, Baltimore, MD21250, USA. e-mail: [email protected]. Phone: (410)-455-2498. Fax: (410)-455-1054.
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Abstract

This paper studies the government spending multiplier in the presence of the cost channel of the nominal interest rate. I find that the spending multiplier of normal times declines markedly when this channel is introduced. The rise in government spending leads to a rise in the nominal interest rate and, with the cost channel, to a rise in the marginal cost and inflation. In turn, this leads to a bigger rise in the nominal interest rate and the expected real interest rate, hence a lower multiplier, than in a model that abstracts from the cost channel. On the other hand, in a liquidity trap, the cost channel makes the spending multiplier larger. Therefore, by ignoring the cost channel, the spending multiplier is overestimated in normal times and underestimated during liquidity trap episodes. Since liquidity traps are rare, however, the spending multiplier is mostly lower than in previous estimates.

Keywords

Government Spending MultiplierCost ChannelFiscal PolicyMonetary Policy
Type
Articles
Information
Macroeconomic Dynamics , Volume 26 , Issue 1 , January 2022 , pp. 72 - 101
Copyright
© Cambridge University Press 2020

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Footnotes

I am grateful to William A. Barnett (the editor), the associate editor and two anonymous referees for very invaluable comments and suggestions.

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