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Dr. Pontus Rendahl

University of Cambridge, United Kingdom

Abstract: This paper studies a model of equilibrium unemployment in which the efficacy of fiscal policy increases markedly in times of crises. A sudden rise in pessimism leads households to save rather than to spend, causing a fall in output and rising unemployment. But as a persistent rise in unemployment fuels pessimism, the economy is set on a downward spiral in which thrift reinforces thrift. The government can put this process to an end. An expansion in public spending bolsters demand and lowers the unemployment rate both in the present and in the future. Pessimism is replaced by optimism and the vicious cycle is turned into a virtuous. The marginal impact of government spending on output is negative during normal times. But in a severe recession the fiscal multiplier rises to about three, and expansionary fiscal policy is unambiguously Pareto improving.

Full Text:  “Fiscal Policy in an Unemployment Crisis”