Fiscal Policy in a Model With Financial Frictions

What are the effects of fiscal policy in the presence of financial frictions? This question is particularly relevant given the great recession of 2008–2009, how forcefully some governments have resorted to fiscal stimulus over the last two years to fight it, and the widespread view that financial markets have played a decisive role in our current economic problems. To analyze this topic, I build a dynamic stochastic general equilibrium (DSGE) model with financial frictions and fiscal policy, calibrate it to observations of the US economy, and compute the response of output to several fiscal shocks. I. A DSGE Model with Financial Frictions and Fiscal Policy Due to space constraints, I will only briefly describe the main elements of the model that I employ for my investigation. The interested reader can find a more detailed exposition in Fernández-Villaverde (2010). Suffice it to say in terms of motivation that the model is based on the work