The Nonlinear Effects of Fiscal Policy

RePEc Short ID: pfa225
ORCID iD: 0000-0002-3759-2172

Brinca, Pedro; Faria-e-Castro, Miguel; Ferreira, Miguel H.; Holter, Hans; Nóbrega, Valter

doi:10.20955/wp.2019.015

Working Paper Revision

The Nonlinear Effects of Fiscal Policy

Abstract: We argue that the fiscal multiplier of government purchases is nonlinear in the size of the spending shock. In particular, the multiplier is increasing in the spending shock, with more expansionary government spending shocks generating larger multipliers and more contractionary shocks generating smaller multipliers. We document that empirically this holds true across time, countries and types of shocks. We then propose a neoclassical mechanism that hinges on the relationship between fiscal shocks, their form of financing, and the response of labor supply across the wealth distribution. A neoclassical incomplete markets model predicts that the aggregate labor supply elasticity is increasing in the spending shock, and this holds regardless of whether shocks are deficit- or balanced-budget financed. We show this mechanism to still be the driving force of the nonlinear effects of fiscal policy in the presence of nominal price rigidities. We find evidence for our mechanism using micro-data for the US.

Keywords: fiscal multipliers; nonlinearity; asymmetry; heterogeneous agents;

JEL Classification: E21; E62;

https://doi.org/10.20955/wp.2019.015