DP12394 Financial Fragility and the Keynesian Multiplier

Author(s): Christiaan van der Kwaak, Sweder van Wijnbergen
Publication Date: October 2017
Keyword(s): Financial Intermediation, Fiscal policy, Macrofinancial Fragility, Sovereign Default Risk
JEL(s): E44, E62, H30
Programme Areas: International Macroeconomics and Finance
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=12394

Abstract We investigate the effectiveness of fiscal stimuli when banks are undercapitalized and have large holdings of government bonds subject to sovereign default risk. Deficit-financed government purchases then crowd out private expenditure and fiscal multipliers can turn negative. Crowding out increases for longer maturity bonds and higher sovereign default risk. We estimate a DSGE model with financial frictions for Spain and find that investment crowding out indeed leads to a negative cumulative fiscal multiplier. When monetary policy is exogenous, like at the ZLB or in a currency union, fiscal stimuli become more effective but multipliers are reduced when banks are undercapitalized.