Fiscal policy stabilization: Purchases or transfers?

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Author:

Neil R. Mehrotra, Assistant Professor of Economics, Brown University and Visiting Junior Scholar, Federal Reserve Bank of Minneapolis

Abstract:

Both government purchases and transfers figure prominently in the use of fiscal policy for counteracting recessions. However, existing representative agent models including the neoclassical and New Keynesian benchmark rule out transfers by assumption. This paper explains the factors that determine the size of fiscal multipliers in a variant of the Curdia and Woodford (2010) model where transfers now matter. I establish an equivalence between deficit-financed fiscal policy and balanced-budget fiscal policy with transfers. Absent wealth effects on labor supply, the transfer multiplier is zero when prices are flexible, and transfers are redundant to monetary policy when prices are sticky. The transfer multiplier is most relevant at the zero lower bound where the size of the multiplier is increasing in the debt elasticity of the credit spread and fiscal policy can influence the duration of a zero lower bound episode. These results are quantitatively unchanged after incorporating wealth effects on labor supply.