Fiscal tools at the zero lower bound: A DSGE model with occasionally binding constraints on monetary policy and borrowing

The paper analyses the effectiveness of fiscal tools at the zero lower bound (ZLB). A non-linear New Keynesian DSGE model with occasionally binding constraints on monetary policy and borrowing is applied. When the ZLB binds in a liquidity trap, government spending becomes more effective in stimulating output whereas cuts in the income tax may lower output in the short run. Although the government spending multiplier increases at the ZLB, its size depends strongly on rational expectations to the liquidity trap length. In the beginning of 2009 market expectations reflected anticipations of a short stay at the ZLB. However, the American Recovery and Reinvestment Act was implemented on the basis of official reports and dominating literature that suggested the spending multiplier to be above 1 by assuming a long stay at the ZLB. Borrowing is based on the collateral value of the household's stock of housing, and this credit channel has a negative implication on the effectiveness of government spending as a stabilising instrument due to a fall in the housing price. However, the channel might turn positive at the ZLB when allowing for public debt financing because of a wealth transfer to the borrowing household.