Government spending multipliers and the zero lower bound

It is well-known that when the nominal interest rate hits the zero lower bound, the size of the fiscal multiplier can be large. The effectiveness of fiscal stimulus depends on the duration and the expected duration of the zero-lower-bound regime. Most studies fix this duration and therefore suffer from a bias. In this paper, we propose a way to estimate the government spending multiplier that allows this duration to be endogenously determined. Specifically, we incorporate into the Smets and Wouters (2007) model a monetary policy reaction function that follows a two-state Markov-switching process, and use data to pin down the transitional probability from one policy regime to the other. We then estimate the model and compute the fiscal multiplier using a data set that spans 1985:2–2015:3.