Rotterdam Brown Bag Seminars General Economics

Bas Jacobs (Erasmus University Rotterdam)
Wednesday, 22 November 2017

Abstract: This paper develops a normative public finance framework to answer three fundamental questions of macro-economic stabilization policy: i) Should fiscal policy be used to stabilize the business cycle during a (deep) recession? ii) If so, how much fiscal stimulus is optimally needed? iii) Which type of tax and spending policies should optimally be employed? To answer these questions, a version of the canonical New-Keynesian model is developed with price rigidities, the zero lower bound (ZLB) on nominal short-term interest rates, and rigid nominal wages. This paper demonstrates that optimal fiscal policies are geared towards removing the underlying macro-economic distortions created by recessions. In particular, a sufficiently flexible fiscal instrument set of the government removes all distortions created by price rigidities, the ZLB and wage rigidities. Optimal policies follow standard Pigouvian prescriptions and ensure that intertemporal and labor-market wedges are perfectly eliminated. Optimal fiscal policy implementations generally require wealth taxes, labor subsidies and investment tax credits. The classical Keynesian fiscal multiplier is generally an insufficient statistic to judge the desirability of stabilization policy. Optimal public goods provision should generally follow classical principles, unless there are severe restrictions on the government instrument set.