Fiscal spending multipliers with imperfect substitutability between long- and short-term bonds
We illustrate in a tractable New Keynesian model that imperfect asset substitutability in the bond market can serve as an important channel for fiscal policy away from the effective lower bound on interest rates. Specifically, in the presence of imperfect asset substitution, government spending shocks can generate a positive consumption multiplier if the fiscal authority finances the shock by issuing bonds of a relatively shorter maturity. This channel works through the imperfect pass-through from short- to long-term bonds, inducing fluctuations in the interest rate spread. This spread is shown to have a substantial impact on consumption decisions.
As can be seen from the chart above the stimulus spending of the American Recovery and Reinvestment Act (ARRA) of 2009, and subsequent roll-overs, have been primarily through the issuance of long-term bonds. The results derived from this paper’s model imply that the choice of financing by the US Treasury may have reduced the effectiveness of fiscal stimulus when it was needed most.
Government Spending Multipliers and Imperfect Asset Substitution
Authors: John Nana Francois, Andrew Keinsley
From: West Texas A&M University, Weber State University
