This project studies the size of the fiscal multiplier in a model with incomplete markets and sticky wages and prices. Allowing for incomplete markets instead of complete markets---the prevalent assumption in the literature---comes with two advantages. First, the incomplete markets model delivers a realistic distribution of the marginal propensity to consume across the population, whereas all households counterfactually behave according to the permanent income hypothesis if markets are complete. The stimulative effects of higher government spending on wages and employment has now distributional effects, benefiting those without capital income and a high propensity to consume. We show that a proper quantitative assessment of these redistributional effects requires to incorporate (realistically) rigid wages into the model.
Second, in our model the response of prices, output, consumption and employment is uniquely determined by fiscal policy for any monetary policy as opposed to most of the previous literature, where there can exist an infinite number of equilibria, leaving the researcher to arbitrarily pick one. Our preliminary findings indicate a much smaller fiscal multiplier than commonly found in past studies. We also study the effect of other policies such as more progressive taxation and imposing minimum wages.