The anatomy of fiscal dynamics in a model with financial frictions

Abstract

This paper studies the role of financial frictions in generating different model dynamics in response to fiscal policy. I build financial-friction edifices on a canonical business-cycle model to quantitatively assess dynamics of macroeconomic aggregates and fiscal variables following various fiscal shocks. Models that are fit to U.S. data reveal that the presence of financial frictions is the linchpin of delivering markedly different outcomes. The model with financial frictions yields higher output multipliers and better fiscal health than the model without financial frictions for most fiscal instruments. Welfare analyses also show that welfare gains in the model with financial frictions are larger than the frictionless model. Various counterfactual analyses suggest that different financial frictions produce substantially different results. These analyses highlight the importance of accounting for financial frictions to better understand the impact of fiscal policy.