Discussion paper

DP12394 Financial Fragility and the Keynesian Multiplier

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.


van Wijnbergen, S and C van der Kwaak (2017), ‘DP12394 Financial Fragility and the Keynesian Multiplier‘, CEPR Discussion Paper No. 12394. CEPR Press, Paris & London. https://cepr.org/publications/dp12394