We are in a new macroeconomic order. Whereas monetary policy was the main tool to moderate business cycle fluctuations at the onset of the Great Recession, such tools are now no longer as effective. The problem is that the U.S. economy is in a liquidity trap, a situation in which even zero nominal interest rates are insufficiently low to produce full employment. But the macroeconomic picture is bleaker still. Not only is conventional monetary policy impotent in counteracting fluctuations, but also the trend line itself – potential output – around which the economy fluctuates, is becoming flatter. Thus, with the effectiveness of monetary policy sharply reduced, fiscal policy assumes greater significance. But just how effective is fiscal policy in a liquidity trap?
Turning to Theory
The IS-MP macroeconomic framework suggests that fiscal policy is potent in a liquidity trap. The key insight is that if an economy is in a liquidity trap, nominal interest rates are likely higher than the monetary authorities would like them to be; rates would be lower if not for the zero lower bound. Thus, the central bank is unlikely to respond to fiscal stimulus by raising rates as it would in normal economic circumstances. The normal “crowding-out” of fiscal stimulus is muted, and the fiscal multiplier is larger.
Delong and Summers (2012) present a plausible case for why real interest rates could actually decrease in response to fiscal stimulus. They argue that while inflation increases with output, the interest rate spreads for duration, default, and other risks could decrease with output; the logic is that in more prosperous economies, there are fewer defaults and thus the price for bearing risk is smaller.
Research conducted by Simon Kwan of the SF Fed presents mixed support for this view. Using Robert Shiller’s cyclically adjusted price-earnings ratio as a proxy for the inverse of the price of risk for holding stocks over the long term, and the spread of the bond yield over a Treasury security for the price of risk for corporate bonds, Kwan demonstrates that there was a significant rebound in risk-taking during the recovery from the Great Recession. However, he concludes that the pace of economic growth does not appear to explain this increase in risk appetite; rather, the pace of corporate profit growth and the severity of the recession (before the recovery) are better predictors of risk appetite. Although Delong and Summers may be incorrect in focusing on output, Kwan’s paper shows that risk spreads do decrease during recoveries, lending credence to the view that lower real interest rates (and thus higher investment) could provide additional stimulus to fiscal policy in a liquidity trap.
There is substantial variation in the empirical literature on the size of the fiscal multiplier. For example, Nakamura and Steinsson (2011) find that government spending has large output multipliers (1.5+) in a liquidity trap. They exploit regional variation in military spending in the U.S. to estimate the government expenditures multiplier in a monetary union. Using New Keynesian models, Eggertsson (2011), Woodford (2011), and Christiano et al. (2011) also show that fiscal multipliers can be large at the zero lower bound. In contrast, by analyzing quarterly historical U.S. data covering multiple major wars and recessions, Ramey and Zubairy (2014) find inconclusive evidence that the fiscal multiplier is larger at the zero lower bound.
Much of the variation in these estimates is due to different assumptions about price rigidity. The reason is that a transitory increase in government spending would cause prices to rise gradually if prices are sticky, as they are assumed to be in New Keynesian models; by contrast, under the neoclassical assumption of flexible prices, prices would jump up immediately in response to the fiscal shock and then begin falling. Thus, in the first case we have inflation, and in the second case we have deflation. With constant nominal interest rates (as in a liquidity trap), real rates would fall in the former case and rise in the latter. This difference accounts for the wide range of estimates of the fiscal multiplier.
So, are prices sticky or flexible? Paul Krugman argues that the strong correlation between nominal and real exchange rates is a key piece of evidence in favor of sticky prices. A recent paper from the SF Fed also supports this view, citing evidence of downward nominal wage rigidity. In particular, despite the severity of the Great Recession, a large fraction of wages were frozen rather than cut, suggesting that a large fraction of employers settled for zero nominal wage growth rather than wage cuts. This problem is arguably more severe in a liquidity trap, as inflation is typically low and hence pent-up wage cuts take longer to subside. Hence, if prices are indeed sticky, New Keynesian models are likely correct, and the fiscal multiplier is large in a liquidity trap.
Both theory and empirical evidence suggest that fiscal policy is potent in a liquidity trap. Granted, there are other policy responses that are tenable at the zero lower bound. One such response is quantitative easing (QE), the purchasing of long-term government bonds and risky assets by the central bank. QE not only has the direct effect of lowering long-term real interest rates, but arguably also has expectational effects; the idea is that a central bank promising future inflation (to lower real interest rates) will be more credible if it is taking active measures – such as QE – to increase the monetary base. QE has recently come under fire, however, by scholars who warn that exiting QE will be challenging. With respect to the U.S., when the economy recovers and the Fed moves to drain excess reserves by selling long-term bonds and stopping its reinvestment of the proceeds of maturing bonds, the bond market could push long-term rates higher than warranted by economic fundamentals, consequently slowing growth and preventing the Fed from raising short-term rates. Thus, QE could have lingering effects. All of this demonstrates that the U.S. economy is largely in unchartered waters, and that being in a liquidity trap has changed the nature of macroeconomics.
 Larry Summers. U.S. Economic Prospects: Secular Stagnation, Hysteresis, and the Zero Lower Bound. Business Economics. February 24, 2014.
 J. Bradford Delong and Lawrence H. Summers. Fiscal Policy in a Depressed Economy. Brookings Papers on Economic Activity. Spring 2012.
 Simon Kwan. The Price of Stock and Bond Risk in Recoveries. FRBSF Economic Letter. Federal Reserve Bank of San Francisco. August 19, 2013.
 Emi Nakamura and Jon Steinsson. Fiscal Stimulus in a Monetary Union: Evidence from U.S. Regions. National Bureau of Economic Research. September 2011.
 Valerie A. Ramey and Sarah Zubairy. Government Spending Multipliers in Good Times and in Bad: Evidence from U.S. Historical Data. November 22, 2014.
 I asked Professor Nakamura why prices would fall, and she said that one way to see this is by noting that in the neoclassical model, real interest rates rise in response to a positive demand shock. If nominal rates are fixed at zero (as in the zero lower bound case), then the only way for real interest rates to rise is for prices to fall. To see why prices jump up in the first place, we note that prices must eventually revert to normal, since the demand shock is only temporary and the money supply is constant. Thus, for prices to be able to fall back to their original levels after the demand shock, they must initially jump up. Emi Nakamura and Jon Steinsson. Fiscal Stimulus in a Monetary Union: Evidence from U.S. Regions. National Bureau of Economic Research. September 2011.
 Exchange Rates and Price Stickiness (Wonkish). New York Times. February 5, 2011. http://krugman.blogs.nytimes.com/2011/02/05/exchange-rates-and-price-stickiness-wonkish/?_r=0
 Daly, Mary C., and Bart Hobijn. “Downward Nominal Wage Rigidities Bend the Phillips Curve.” FRB San Francisco Working Paper 2013-8. 2013; Mary C. Daly, Bart Hobijn, and Timonthy Ni. The Path of Wage Growth and Unemployment. FRBSF Economic Letter. July 15, 2013.
 Paul Krugman. Thinking about the Liquidity Trap. Journal of Japanese and International Economies. October 2000.
 Richard Koo. The Escape from Balance Sheet Recession and the QE Trap. John Wiley & Sons. 2015. 98-101; http://www.bloombergview.com/quicktake/federal-reserve-quantitative-easing-tape