Fiscal Stimulus in Liquidity Traps: Conventional or Unconventional Policies?

Abstract

Recent influential work argue that a gradual increase in sales tax stimulates economic activityin a liquidity trap by boosting inflation expectations. Higher public infrastructure investmentshould also be more expansive in a liquidity trap than in normal times by raising the potentialinterest rate and increasing aggregate demand. We analyze the relative merits of these policiesin New Keynesian models with and without endogenous private capital formation andheterogeneity when monetary policy does not respond by raising policy rates. Our key findingis that the effectiveness of sales tax hikes differs notably across various model specifications,whereas the benefits of higher public infrastructure investment are more robust in alternativemodel environments. We therefore conclude that fiscal policy should consider publicinvestment opportunities and not merely rely on tax policies to stimulate growth during theCOVID-19 crisis.3