Fiscal Policy in a Depressed Economy

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The new Brookings Paper by Larry Summers and Brad DeLong, Fiscal Policy in a Depressed Economy, is an important document and should be widely read. It explains the conditions under which fiscal stimulus can be self-financing.

In normal times central banks offset the effects of fiscal policy. This keeps the policy-relevant multiplier near zero. It leaves no space for expansionary fiscal policy as a stabilization policy tool. But when interest rates are constrained by the zero nominal lower bound, discretionary fiscal policy can be highly efficacious as a stabilization policy tool. Indeed, under what we defend as plausible assumptions, temporary expansionary fiscal policies may well reduce long-run debt-financing burdens.

If you are at the zero bound, have hysteresis in output and employment (likely in severe recessions), and your long-term interest rates are low, you need only a fairly modest fiscal multiplier for stimulus to improve the long-term debt position. Not many countries are in this position--but the US is one, and the UK is another.

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