How Costly is Fiscal Stimulus over the Business Cycle? 

Job Market Paper

Abstract: This paper quantifies the cost of an additional dollar of fiscal stimulus in future tax increases (fiscal adjustment) in the U.S. quarter by quarter from 1962 to 2026. I build a medium-scale, two-agent New Keynesian model with downward nominal wage rigidity and estimate it using Bayesian methods. Downward nominal wage rigidity is an occasionally binding constraint that gives rise to unemployment in downturns, making the model’s dynamics nonlinear over the business cycle. To account for these nonlinearities, I derive a new present-value measure of fiscal adjustment that is conditional on the state of the economy and use it to quantify fiscal adjustment over time. I find that on average the government needs to raise about $1.02 in future taxes for each dollar of fiscal stimulus. Stimulus is least costly in an economy with idle resources and low inflation because it is more likely to raise output than prices, expanding the tax base and increasing tax revenues. An example is the Great Recession, when fiscal adjustment was about $0.98 for each dollar of stimulus in 2009Q1. In contrast, stimulus is most costly when it raises inflation more than output, prompting the monetary authority to raise interest rates and making debt more expensive to service. Examples include the 1970s oil crisis and the COVID recovery, when fiscal adjustment was $1.06 in 1974Q3 and $1.07 in 2021Q1, respectively.

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