Hafedh Bouakez, HEC Montréal

"The Optimal Composition af Public Spending in a Deep Recession"


We study optimal fiscal policy in an economy where monetary policy is constrained by the zero lower bound on the nominal interest rate, and where the government can allocate spending to public consumption and public investment. We show that the optimal response to an adverse shock that precipitates the economy into a liquidity trap entails a small and short-lived increase in public consumption but a large and persistent increase in public investment, which lasts well after the natural rate of interest has ceased to be negative. During this period, the optimal composition of public spending is therefore heavily skewed towards public investment. Contrary to the literature that abstracts from public investment, we find that the optimal increase in total public spending in a deep recession is sizable. To the extent that monetary policy is set optimally, this fiscal expansion has little to do with a stabilization motive and is instead mainly warranted by the intertemporal allocation of resources that efficiency dictates. In contrast, when monetary policy is sub-optimal, there is an important scope for using public spending in general and public investment in particular as a stabilization tool.

(Co-authors: with Michel Guillard and Jordan Roulleau-Pasdeloup)

Link to paper

Contact persons: Emiliano Santoro and Søren Hove Ravn