Department of Economics

Can Fiscal Stimulus Overcome the Zero Interest-Rate Bound?

Department of Economics

University of Delaware

Working Paper #2005-19

Can Fiscal Stimulus Overcome the Zero Interest-Rate Bound?:
A Quantitative Assessment

Kenneth Lewis and Laurence Seidman

Abstract

This paper provides a quantitative assessment of the use of fiscal stimulus to achieve full recovery from a severe recession when the potency of monetary policy weakens after hitting its zero interest-rate bound.  By contrast, most of the numerous recent zero interest-rate bound papers have ignored the use of fiscal stimulus, preferring to examine whether monetary policy alone can revive the economy despite the zero bound.  We obtain our estimates by adapting and simulating a macro-econometric model that has been recently econometrically estimated, updated, and statistically tested using U.S. times series data.  By contrast, most of the recent zero bound papers do not use an econometrically-estimated model.  If the U.S. economy were hit with a large negative demand shock that drives the unemployment rate up to 7.9%, we estimate that even aggressive monetary policy that drives long-term interest rates to near zero would reduce the unemployment rate only to 6.7%.  Full recovery would be achieved, however, if the aggressive monetary policy were complemented by sufficient fiscal stimulus in the form of cash transfers or income tax cuts to households.  We estimate that a quarterly transfer to households that peaks at 2.7% of quarterly GDP and phases out gradually as it is repeated over seven quarters (so that the cumulative transfer is roughly 12% of quarterly GDP) would reduce the unemployment rate in such a recession by nearly an additional percentage pointC from 6.7% to 5.9%.

JEL code: E62

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