DP13740 Fiscal Policies in Booms and Busts

Author(s): Paul De Grauwe, Pasquale Foresti, Yuemei Ji
Publication Date: May 2019
Keyword(s): Fiscal Multiplier, Fiscal policy, low and high interest rate regimes, public debt sustainability, tradeoffs
JEL(s):
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=13740

We introduce fiscal policies into a behavioral macroeconomic model. We show how animal spirits play an important role in the dynamics of the business cycle and of public debt. These animal spirits are able to generate different sizes of fiscal multipliers depending on the state of the economy. Depending on the interest rate regime (high or low), they affect the capacity of fiscal authorities to stabilize the economy. In the high interest rate regime the fiscal authorities face a steep trade-off between output stabilization and the stabilization of public debt, i.e. attempts to stabilize the business cycle quickly hit a limitation of debt sustainability. In the low interest rate regime, when the steady state interest rate is lower than the growth rate of the economy, the use of fiscal policy as a tool of output stabilization is made considerably stronger.