policymakers demonstrate

Fiscal and Monetary Policies after the Crises 427
probability – whenever desired savings remain high – the result is a higher
ex-ante expected value for inflation at t + 1. This reduces the real interest rate
in period t, meaning C t will also rise, and Y t will increase still further with it.
Symmetrically, higher expected consumption can be expected in ‘bad’ states
at t + 1, and this further reduces the benefits from saving in t: in mathematical
terms, the value of u ′ (C t+1 ) is no longer so high in expectation. This feeds back
into still more consumption and output in period t. The overall consequence is
a multiplier, dY t
dG t
, that is significantly greater than one. It is not just employment
and public consumption that rise – private consumption does so too.
An important lesson from this is that the theoretical case for high multipliers
at the zero bound – that is, multipliers in excess of one – relies on an inflation
expectations channel. Without the effect of higher G t+1 on π t+1 , a rise in G t
could increase Y t but not C t – at least in our basic setting. Yet large fiscal stimulus
packages seem a very blunt instrument for increasing inflation expectations.
It may be the case that conditional on underemployment, resources are better
used by the public sector than standing idle, but this seems too readily to give
up on the idea that output could be restored to the level of productive capacity
by other means. 26 Given that the political direction of travel in EU states at
present seems to be towards reduced fiscal deficits, the headline results on the
multiplier – though important – have perhaps attracted more attention than is
now warranted.
Fiscal Stimulus in Stressed Economies
Indeed, a number of authors have highlighted that the benefits to fiscal expansion
could easily be undone if the fiscal solvency of the government comes
to be questioned – an issue that is of obvious relevance to southern European
countries at present. The paper by Corsetti et al. (2013) explores theoretical
mechanisms that would generate a spread between the nominal interest rate
set by the central bank and the nominal rate that is of relevance to consumer
saving and borrowing decisions. Their framework allows for multiple countries
and multiple consumers, some of whom borrow and some save. 27 But the essential
point can again be made by reference to the Euler equation. The nominal
interest rate faced by consumers is now i c t = i t + ω t , where i t is again the central
bank rate and ω t measures the period-t interest rate spread. This spread is in
turn assumed to depend positively on the size of the fiscal deficit: higher deficits
raise the interest rate spread, and the marginal effect of the current deficit on the
spread is in turn increasing in the existing size of outstanding government debt.
Returning to the Euler condition, and assuming that the central bank’s interest
rate is zero, we will have:
u ′ (Y t − G t ) = β t E t
1 + ω t (G t − τY t )
1 + π t+1
u ′ (Y t+1 − G t+1 ) , (10.7)