Fiscal policy under deflationary gap and long-run stagnation: Reinterpretation of Keynesian multipliers

- We develop a simple Keynesian-cross analysis in a dynamic optimization model.
- We show long-run stagnation with aggregate demand deficiency to arise.
- An increase in government purchases boosts GDP through a multiplier process.
- A transfer has no effect on GDP.
- Creating new employment by fiscal expansion is essential for stimulating business activity.

We develop a Keynesian cross analysis with a dynamic optimization setting that explains long-run stagnation caused by aggregate demand deficiency. We show that an increase in government purchases boosts GDP through a multiplier process, but the implication is quite different from the conventional Keynesian one. It works not through an increase in disposable income but through moderation of deflation. Thus, countries that have lapsed into long-run stagnation should expand government spending that directly creates employment in order to reduce the deflationary gap.