The Fiscal Multiplier

Abstract

This paper studies the size of the fiscal multiplier in a model with incomplete mar-kets and rigid prices and wages. Allowing for incomplete markets instead of complete markets—the prevalent assumption in the literature—comes with two advantages. First, the incomplete markets model delivers a realistic distribution of the marginal propen-sity to consume across the population, whereas all households counterfactually behave according to the permanent income hypothesis if markets are complete. Second, in our model the response of prices, output, consumption and employment is uniquely deter-mined by fiscal policy for any monetary policy including the zero-lower bound (ZLB) as opposed to most of the previous literature, where an infinite number of equilibria exists, leaving the researcher to arbitrarily pick one. Our preliminary findings indicate that the impact multiplier is quite large between 2 and 3 depending on whether tax or deficit financing is used and increase to values above 3 in a liquidity trap.