Understanding The Size Of The Government Spending Multiplier PDF Download

This paper assesses the size of the government-spending multiplier in an open economy when the zero lower bound (ZLB) on the nominal interest rate is binding. In a theoretical framework, in a closed economy, other authors have shown that when the nominal interest rate is binding the government-spending multiplier can be very large (close to four). Their theory helps illuminate the government-spending multiplier in the ZLB, but it is difficult to match that theory with the data. We argue that, in an open economy, another channel exists for the crowding-out effect via the real exchange rate. For an open economy, the government-spending multiplier is not large owing to the appreciation of the real exchange rate, induced by the appreciation of aggregate demand that follows the increases in government spending. To test the robustness of our open economic model, we conduct the same analysis in a corresponding closed economy model. The result from our closed economy model confirms the result obtained in the other work. Our theoretical results are consistent with the results obtained in the empirical literature, which uses the vector autoregressive method and the structural vector autoregressive approach to measure the impact of government-spending shock on the real gross domestic product and revealed that the government-spending multiplier tends to be lower in open economy.