Austerity versus stimulus: the polarizing effect of fiscal policy

Through constructing a New-Keynesian DSGE model with heterogeneous agents, this paper investigates both the aggregate and distributional consequences of fiscal policy. Polarized preferences over the conduct of fiscal policy emerge between those agents who participate in credit markets and those who do not. Exogenous shocks impact the two types of agent differently, and, as a result, fiscal policy responses to these shocks produce minimal aggregate welfare effects as the gains of one agent are matched by the losses of another. There is, therefore, a normative justication for countercyclical fiscal policy, but on redistributive rather than stabilisation grounds.