Thursday, 11 March 2010
Here I scratch the surface of a more general question: the effects of Fiscal consolidation at the zero interest lower bound which is not far from where the EMU and US short term interest rates are right now. This suggests that what we should debate is Fiscal consolidation at the zero interest lower bound and not Fiscal consolidation tout-court. In the last two years Macroeconomists have (re)-learned that in a liquidity trap the fiscal multiplier is at maximum and larger than in normal times. Therefore elasticities estimated in samples that do not contain periods of near zero interest rates might not be reliable for near-liquidity trap periods. This observation has another implication: if fiscal multipliers are larger when interest rates are close to the zero lower bound, fiscal consolidation should be performed during times when the economy is far from the lower bound. Wait, it becomes worse: at the zero interest rate lower bound, the larger contractionary effect of fiscal policy increases the probability of maintaining the interest rates at zero, making it more difficult to escape from the trap. There are many caveats, the most obvious regard interest rates payments on national debt (the longer we wait the larger are the payments) and credibility. Let me conclude by suggesting that the escape from near-zero interest rate lower bound in a monetary union necessarily involves an increase in aggregate demand in the monetary union. This would suggest to have fiscal consolidation plans contingent with the EMU recovery and monetary policy normalization.
Posted by Francesco Franco at 16:37