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The Nonlinear Effects of Fiscal Policy

We argue that the fiscal multiplier of government purchases in incomplete markets models is nonlinear in the spending shock, in contrast to the multiplier in complete markets models and what is assumed in most of the literature. In particular, the multiplier is increasing in the spending shock, with large positive shocks having the largest multiplier and large negative shocks having the smallest multiplier. The mechanism hinges on the relationship between fiscal shocks, their form of financing, and the response of labor supply across the wealth distribution. The model predicts that the aggregate labor supply elasticity is increasing in the fiscal shock, and this holds regardless of whether shocks are deficit- or balanced-budget financed. Our findings are consistent with aggregate fiscal consolidation data across 15 OECD countries over time. Furthermore, we find evidence of our mechanism in microdata for the US.

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