Working Paper No. 475
By Charles T Carlstrom, Timothy S Fuerst and Matthias Paustian
This paper revisits the size of the fiscal multiplier. The experiment is a fiscal expansion under the assumption of a pegged nominal rate of interest in linearised sticky price model. We demonstrate that a quantitatively important issue is the articulation of the exit from the policy experiment. If the monetary-fiscal expansion is stochastic with a mean duration of T periods, the fiscal multiplier can be unboundedly large. However, if the monetary-fiscal expansion is for fixed T periods, the multiplier is much smaller. Our explanation rests on a Jensen’s inequality-type argument: the deterministic multiplier is convex in duration, and the stochastic multiplier is a weighted average of the deterministic multipliers. The quantitative difference in the two multipliers also arises in a model with capital, and in the baseline non-linear model. However, the difference between the two is less pronounced in the non-linear models. The errors from a linear approximation are much larger for the stochastic exit model than for the deterministic exit model. Thus, we conclude that the deterministic exit model should be preferred.