The Road to Recovery: Fiscal Stimulus, Financial Sector Rehabilitation, and Exit from Policy Easing

Abstract

The worst of the global financial crisis is probably behind us, but the trajectory to recovery may vary widely across economies. Employing a dynamic structural multi-country model with a financial accelerator, this paper studies the role of three important policy actions in economic recovery: fiscal stimulus, financial sector rehabilitation and exit from policy easing. The main finding is that while both fiscal stimulus and financial sector rehabilitation contribute to economic recovery, the former is likely to be less effective from a medium-term perspective and may generate some negative side effects. This finding suggests that policy priority (of advanced economies in particular) should be on continued financial sector rehabilitation. Moreover, international policy co-ordination is beneficial as it can generate spillovers to regional economies. We also study the effects of over-estimation of the post-crisis potential output by the monetary authorities in advanced economies in their policymaking. We find that this may affect economic recovery in the region through inflationary pressure and the consequent policy tightening.

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