Fiscal Policy in a Model With Financial Frictions

Jesús Fernández-Villaverde
2010 The American Economic Review  
What are the effects of fiscal policy in the presence of financial frictions? This question is particularly relevant given the great recession of 2008-2009, how forcefully some governments have resorted to fiscal stimulus over the last two years to fight it, and the widespread view that financial markets have played a decisive role in our current economic problems. To analyze this topic, I build a dynamic stochastic general equilibrium (DSGE) model with financial frictions and fiscal policy,
more » ... d fiscal policy, calibrate it to observations of the US economy, and compute the response of output to several fiscal shocks. I. A DSGE Model with Financial Frictions and Fiscal Policy Due to space constraints, I will only briefly describe the main elements of the model that I employ for my investigation. The interested reader can find a more detailed exposition in Fernández-Villaverde (2010). Suffice it to say in terms of motivation that the model is based on the work of Ben S. Bernanke, Mark Gertler, and Simon Gilchrist (1999) and Lawrence J. Christiano, Roberto Motto, and Massimo Rostagno (2009) that has successfully been applied to study business cycle dynamics. The model has a representative household, final and intermediate good producers, producers of capital, entrepreneurs, financial intermediaries, and a government that conducts monetary and fiscal policy. The financial frictions appear as a consequence of information asymmetries between lenders and borrowers. The representative household maximizes: where c t is consumption, l t hours worked, p t the price level, m t−1 /p t real money balances carried into the period, β the discount factor, h habit persistence, and ϕ t an intertemporal preference shock with law of motion: The intertemporal shock allows me to account for shifts in aggregate demand in a simple way. The household can save using: • Money balances to carry into the next period, m t . • Nominal deposits at the financial intermediary, a t , which pay an uncontingent nominal gross interest rate R t . • Nominal public debt, d t , which yields an uncontingent nominal gross return Rd t . • Arrow securities over all possible events (which, however, I do not include explicitly in the notation since they are in zero net supply). Given the portfolio possibilities, the household's budget constraint is: where consumption is taxed at rate τ c,t , the real wage w t is taxed at a rate τ l,t , the net returns on deposits are taxed at rate τ R,t , T t is a lump sum transfer from the result of open market operations of the monetary authority, Ϝ t are the profits of the firms in the economy (financial and
doi:10.1257/aer.100.2.35 fatcat:3uvpbnojgnhkplyrrjhlm67ueu