What Fiscal Policy is Effective at Zero Interest Rates? - Federal Reserve Bank of New York

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Staff Reports

What Fiscal Policy is Effective at Zero Interest Rates?

November 2009 Number 402

JEL classification: E52

Author: Gauti B. Eggertsson

Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures. Another example is a cut in capital taxes. This tax cut deepens a recession because it encourages people to save instead of spend at a time when more spending is needed. Fiscal policies aimed directly at stimulating aggregate demand work better. These policies include 1) a temporary increase in government spending; and 2) tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply, such as an investment tax credit or a cut in sales taxes. The results are specific to an environment in which the interest rate is close to zero, as observed in large parts of the world today.

Available only in PDF pdf

36 pages / 381 kb

For a published version of this report, see Gauti B. Eggertsson, "What Fiscal Policy is Effective at Zero Interest Rates?" NBER Macroeconomics Annual 2010 25 (May 2011): 59-112.

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