Optimal Government Spending at the Zero Bound: Nonlinear and Non-Ricardian Analysis

This paper characterizes optimal government spending when monetary policy is constrained by the zero lower bound under a variety of assumptions about a set of fiscal instruments available to finance government spending. The private sector of the model is given by a standard New Keynesian model. In response to a large and persistent time-preference shock, government chooses a sequence of nominal interest rate and government spending, which can be financed by either lump-sum tax, a mix of labor income tax and debt, or a mix of consumption tax and debt. There are four main findings. First, optimal government spending policy is characterized by an initial expansion followed by a sharp reduction during the period of zero nominal interest rates. Second, optimal dynamics of debt and primary balance depend on the available distortionary tax and the initial level of debt. Third, welfare gain of having government spending as an additional policy instrument depends importantly on the available distortionary tax, but is generally much smaller than welfare gain of having debt instrument or distortionary tax. Finally, welfare gains of various fiscal instruments are larger in the economy with larger initial debt.