The Nonlinear Effects of Fiscal Policy

Abstract

We argue that the fiscal multiplier of government purchases is increasing in the shock, in contrast to what is assumed in most of the literature: the fiscal multiplier is largest for large positive government spending shocks and smallest for large contractions in government spending. We empirically document this fact by analyzing two independent datasets and using two different empirical approaches. We find that a neoclassical, life-cycle, incomplete markets model calibrated to match key features of the US economy, including the distribution of wealth, can well explain this empirical finding. The mechanism works through the relationship between fiscal shocks, the distribution of wealth and the aggregate labor supply elasticity: liquidity constrained agents have less elastic labor supply responses to changes in future income. An increase (decrease) in government spending today acts as a negative (positive) shock to future income, as future wages will be lower (higher). A large increase (decrease) in government spending today will induce saving (borrowing) and move a larger fraction of the agents in the economy away from (towards) the borrowing limit. Analysis of micro-data confirms the mechanism.