Liquidity Constraints and Fiscal Stabilization Policy

It is often claimed that the presence of liquidity constrained households enhances the need for and the effects of fiscal stabilization policies. This paper studies this in a model of a small open economy with liquidity constrained households. The results show that the consequences of liquidity constraints are more complex than previously thought: The optimal stabilization policy in case of productivity shocks is independent of the liquidity constraints, and the presence of liquidity constraints tends to reduce the need for an active policy stabilizing productivity shocks.