New St. Louis Fed Reserve Working Paper: The Nonlinear Effects of Fiscal Policy

The paper The Nonlinear Effects of Fiscal Policy was published in the Federal Reserve Bank of St. Louis Working Paper Series. The paper provides evidence that fiscal multipliers depend both on the size and direction of changes in government spending, how standard representative agent models fail to reproduce such a pattern and how that can be achieved by an overlapping generations version of the standard incomplete markets model. It is joint work with Miguel Faria-e-Castro, Miguel H. Ferreira and Hans A. Holter.

More specifically, We argue that the fiscal multiplier of government purchases is increasing in the spending shock, in contrast to what is assumed in most of the literature. The fiscal multiplier is largest for large positive government spending shocks and smallest for large contractions in government spending. We empirically document this fact using aggregate U.S. data. We find that a neoclassical, life-cycle, incomplete markets model calibrated to match key features of the US economy can explain this empirical finding.The mechanism hinges on the relationship between fiscal shocks, their form of financing,and the response of labor supply across the wealth distribution. The model predicts that the aggregate labor supply elasticity is increasing in the size of the fiscal shock, and this holds regardless of whether shocks are deficit- or balanced-budget financed(albeit through different mechanisms). We find evidence of our mechanism in micro-data for the US.

Click here to access the working paper.