Downward nominal wage rigidity and state-dependent government spending multipliers

• Published in: Journal of monetary economics 2018-10, Vol.98, p.11-26
• Main Authors: Shen, Wenyi, Yang, Shu-Chun S.
• Format: Article
• Language: English
• Subjects: Business cycle-dependent multiplier; Downward nominal wage rigidity; Fiscal policy effects; New Keynesian models; State dependent government spending effects
• ISSN: 0304-3932; 1873-1295
• DOI: 10.1016/j.jmoneco.2018.04.006

•Downward nominal wage rigidity generates business cycle-dependent government spending multipliers.•Government spending in recessions reduces unemployment and does not drive up the real interest rate as much as in expansions.•The baseline simulation generates an impact output multiplier of 1.37 in recession and of 0.54 in expansion.•The theoretical implications are consistent with empirical responses of key macro variables in the literature. Despite much empirical evidence on business cycle-dependent government spending multipliers, the theoretical channels underlying such results are uncertain. In an environment with involuntary unemployment, this paper shows that downward nominal wage rigidity, which arises only in recessions, can generate business cycle-dependent government spending multipliers. In line with Keynesian views, a demand stimulus reduces unemployment in recessions and may not drive up inflation and wages as in expansions. Thus, the positive income effects from reduced unemployment and weaker crowding-out effects from a smaller increase in the real interest rate enhance the expansionary spending effects in recessions. The theoretical implications are largely consistent with existing empirical evidence on business cycle-dependent government spending effects on key macroeconomic variables.