The Government Spending Multiplier in a Model with the Cost Channel

This paper studies the government spending multiplier in the presence of the cost channel of the nominal interest rate. I find that the spending multiplier of normal times declines markedly when this channel is introduced. The rise in government spending leads to a rise in the nominal interest rate and, with the cost channel, to a rise in the marginal cost and inflation. In turn, this leads to a bigger rise in the nominal interest rate and the expected real interest rate, hence a lower multiplier, than in a model that abstracts from the cost channel. On the other hand, in a liquidity trap, the cost channel makes the spending multiplier larger than in a model that does not account for this channel. Therefore, by ignoring the cost channel, the spending multiplier is overestimated in normal times and underestimated during liquidity-trap episodes. Since liquidity traps are rare, however, the spending multiplier is mostly lower than in previous estimates