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We thank Olivier Blanchard, Charles Collyns and Jorg Decressin for encouraging us to do this work.
The published April 2007 WEO projections were extended from 2012 to 2014 by assuming that they were moving towards their long-run steady state values. The actual Fed Funds rates in the figure are monthly data and their projected values for 2010 and 2011 come from the Fed Funds futures market.
We would add that in an economy with many liquidity-constrained agents fiscal activism may be desirable even under flexible exchange rates and away from the zero bound. This is because monetary policy operates mainly through an intertemporal substitution channel that is absent for liquidity-constrained agents. Fiscal policy can directly affect these agents’ income. See Kumhof and Laxton (2009a).
AS comprises China, Hong Kong S.A.R. of China, India, Indonesia, Korea, Malaysia, Philippines, Singapore, and Thailand.
We follow Gali and others (2007) in referring to these households as liquidity-constrained. Other terms used in the literature are rule-of-thumb or hand-to-mouth agents.
Galí and others (2007) interpret the complete inability to smooth consumption of their model’s liquidity-constrained households as (among other possible interpretations) extreme myopia, or a planning horizon of zero. We adopt the same interpretation for the average planning horizon of the finite-horizon model. We therefore allow for the possibility that agents may have a shorter planning horizon than what would be suggested by their biological probability of death. See KLMM for a more detailed discussion.
This stylized treatment of life-cycle income is made possible by the absence of explicit demographics in our model, which means that we only need the assumption of declining labor productivity to be correct for the average worker.
The turnover in the population is assumed to be large enough that the income receipts of the insurance companies exactly equal their payouts.
It is convenient to keep these two items separate in order to account for a country’s overall fiscal accounts, and to allow for targeted transfers to LIQ agents.
Aggregation takes account of the initial size of each age cohort and the remaining size of each generation. For consumption we have
In both this shock and the shock in the next subsection, changes in the deficit are financed by changes in general transfers, and automatic stabilizers function in the normal way.
See Freedman and others (2009b) for a more detailed discussion of fiscal multipliers that also includes government consumption expenditures, consumption taxes and corporate income taxes.
A discretionary reduction of about 1.7 percentage points in the tax rate on labor income is needed to achieve a discretionary increase of 1 percent in the ratio of the government deficit to GDP.
These are based on data collected by the staff of the IMF, as of April 20, 2009.
Transfers that fall under the social safety net heading are treated as targeted transfers for simulation purposes.
We choose the United States for illustrative purposes only. An identical increase in deficits in another region that accounts for a similar share of world GDP would have virtually the same effects on the world economy.
Note that the short-run multipliers are not directly comparable to our earlier exercises. In those simulations the size of the stimulus was expressed as a fraction of pre-stimulus GDP, while here deficits are expressed as a fraction of actual post-stimulus GDP, which is larger.
The U.S. contraction is also larger for general transfers, because their eventual reduction leads to a redistribution from LIQ to OLG households.
Yet another possible linkage between the ratio of public debt to GDP and long-run potential output would be an increase in the risk premium on the public debt in response to a rise in the ratio of debt to GDP because of concerns about the long-run sustainability of the fiscal path. This relationship is not included in the version of GIMF used in this paper.