Austerity versus Stimulus: A DSGE Political Economy Explanation

The 2008 financial crisis and subsequent global economic downturn has brought fiscal policy back onto the political and academic agenda. Despite the vast literature, the discussion is primarily focused upon the fiscal policy multiplier. This positive analysis omits normative consequences from policy and moreover, fails to consider political frictions to policy: something frequently observed in fiscal debates. By constructing a small scale New Keynesian DSGE model with a proportion of credit constrained (non-Ricardian) agents, this paper address these omissions. The results show that there is a normative justification of fiscal policy, in the presence of modest multipliers and the absence of progressive taxes, but on redistributive rather than aggregate grounds. Shocks impact the two agents differently and in polarising ways: countercyclical fiscal policy can be used to alleviate this divergence. However, aggregate improvements from policy are minimal as the gains of one agent are matched by the losses of another, thus giving rise to political frictions and moreover, predicting the current austerity versus stimulus debate.