State Dependent Government Spending Multipliers: Downward Nominal Wage Rigidity and Sources of Business Cycle Fluctuations

Abstract

The recent period of low interest rates have shown that fiscal policies have become crucial for economic recovery. This paper shows that the source of business cycle fluctuations matters for determining the size of government spending multipliers. Here, the authors present a New Keynesian model with downward nominal wage rigidity (DNWR) and show that government spending is much more effective in stimulating output in a demand shock driven recession compared to a supply shock driven recession. Government spending multiplier is large when DNWR binds in a recession, but the nature of recession matters due to the opposing responses of inflation depending on the type of recession. In a demand-driven recession, inflation falls, preventing real wages from falling, leading to consequences for employment, while inflation rises in a supply-driven recession limiting the consequences of DNWR on employment. The authors also document supporting empirical evidence, using both historical time series data and cross-sectional data from U.S. states, that the government spending multiplier for output is larger in a demanddriven recession compared to a supply-driven recession.