Microfoundations of fiscal policy effectiveness: monopolistic competition and fiscal policy multipliers

This paper focuses on the role of imperfect competition as a microfoundation for fiscal policy effectiveness. The seminal papers in this area conclude that the higher the degree of monopoly power the higher the value of fiscal policy multipliers. However, this result has been criticised because it depends on the assumptions of the model. We pay special attention to the assumptions on consumer behaviour, comparing a model with no income effect for the labour supply with a model where leisure is a normal good. Concerning fiscal policy effectiveness we show that the values of the multipliers are positive in any case and that the degree of effectiveness depends heavily on the approach taken. These results highlight the relevance of microfoundations to obtain economic policy conclusions. Regarding the relation between the degree of monopoly power and the value of the multipliers, we conclude that stable relations cannot be established.