STATE DEPENDENCE OF FISCAL MULTIPLIERS: THE SOURCE OF FLUCTUATIONS MATTERS

We develop a general theory of state-dependent fiscal multipliers in a framework featuring two
empirically relevant frictions: idle capacity and unsatisfied demand. Our key novel finding is
that the source of fluctuations determines the cyclicality of multipliers. Policies that stimulate
demand, such as government spending, have multipliers that are large in demand-driven
recessions, but small and possibly negative in supply-driven downturns. Conversely, policies
that boost supply, such as cuts in payroll taxes, are ineffective in demand-driven recessions,
but powerful if the downturn is supply-driven. Austerity, implemented by a reduction in
government consumption, can be the policy with the largest multiplier in supply-side
recessions and demand-driven booms, provided elasticities of labor demand and supply are
sufficiently low. We obtain model-free empirical support for our predictions by developing a
novel econometric specification that allows to estimate spending and tax multipliers in
recessions and expansions, conditional on those being either demand- or supply-driven.