Discussion Paper Series 2010-E-3

The Fiscal Multiplier and Spillover in a Global Liquidity Trap

Ippei Fujiwara, Kozo Ueda

We consider the fiscal multiplier and spillover in an environment in which two countries are caught simultaneously in a liquidity trap. Using an optimizing two-country sticky price model, we show that the fiscal multiplier and spillover are contrary to those predicted in textbook economics. For the country with government expenditure, the fiscal multiplier exceeds one, the currency depreciates, and the terms of trade worsen. The fiscal spillover is negative if the intertemporal elasticity of substitution in consumption is less than one and positive if the parameter is greater than one. Incomplete stabilization of marginal costs due to the existence of the zero lower bound is a crucial factor in understanding the effects of fiscal policy in open economies.

Keywords: Zero lower bound; two-country model; fiscal policy; beggar-thy-neighbor

Views expressed in the paper are those of the authors and do not necessarily reflect those of the Bank of Japan or Institute for Monetary and Economic Studies.

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