Fiscal policy with credit constrained households

This paper explores the effects of discretionary fiscal policy in a DSGE model that explicitly models housing investment and allows for credit constrained households along the lines of the financial accelerator literature.The presence of credit constrained households raises the marginal propensity to consume out of transitory tax reductions and increases in transfers, and makes fiscal policy a more powerful tool for short run stabilisation. Fiscal policy is more effective when credit constraints increase, when measures are temporary, and when monetary policy is accommodative.This is a timely issue in the current financial crisis which can be characterised by a substantial negative demand shock and tighter credit constraints.