to keep output near potential and inflation near its desired level. thus, the enactment of a sustained fiscal expansion would trigger an increase in expected short - term interest rates and hence longterm interest rates. the higher long - term rates would also tend to reduce asset values and boost the foreign exchange value of the dollar. as a result, any initial increase in aggregate the views presented here are my own and not necessarily those of other members of the board of governors or the federal open market committee. eric engen, david reifschneider, and john roberts of the board's staff contributed to these remarks. output and employment from the fiscal expansion would be soon crowded out by reductions in household spending, business investment, and net exports. 2 but in the current weak economic environment, a fiscal expansion may be much more effective in providing a sustained boost to economic activity. with traditional monetary policy currently constrained from further reductions in the target policy rate, and with many analysts forecasting lower - than - desired inflation and a persistent, large output gap, agents may anticipate that the target federal funds rate will remain near zero for an extended period. in this situation, fiscal stimulus could lead to a considerably smaller increase in long - term interest rates and the foreign exchange value of the dollar, and to smaller decreases in asset prices, than under more normal circumstances. indeed, if market participants anticipate the expansionary fiscal policy to be relatively temporary, and the period of weak economic activity and constrained traditional monetary policy to be relatively extended, they may not expect any increase in short - term interest rates for quite some time, thus damping any rise in long - term interest rates. moreover, if the initial boost to aggregate spending from fiscal stimulus raises inflation expectations, then real short - term interest rates would tend to decline, given that the nominal short - term interest rate is constrained at the zero lower bound. all told, the result is likely to be considerably less of the usual crowding out of fiscal stimulus in these circumstances, thereby increasing the effectiveness of fiscal policy to boost the level of aggregate economic activity in the short to medium term. this scenario is supported by simulations using the federal reserve staff's frb / us model, assuming all agents have rational expectations. 3 for example, suppose the level of federal government purchases is increased permanently by 1 percent of gross domestic product ( gdp ). under normal circumstances, the fiscal spending multiplier – that is, the percentage response of real gdp to the boost

in government spending – starts out at about 1 but then quickly falls to zero as long - term interest rates rise so that private spending and exports decline. however, if financial market participants anticipate that the federal funds rate will remain at zero for an appreciable period of time following the hike in government spending, the simulated short - run fiscal multiplier rises to 1. 3 for some time. model simulations also indicate that the fiscal spending multiplier may rise even further – to around 2 – if the fiscal stimulus is expected to be temporary and to last no longer than the period when monetary policy holds short - term interest rates at the zero lower bound. 4 to be sure, greater - than - usual uncertainty surrounds estimates of the size of the fiscal multiplier under current circumstances, and its magnitude could be somewhat smaller than suggested by these model simulations. with lenders unusually cautious, household and business spending may react less than would normally be expected to low real interest rates because tight nonprice credit terms are restricting access to borrowed funds. also, the above - normal levels of uncertainty faced by households and firms could damp the responsiveness of consumption and investment spending to the boost in household income and business earnings generated by the fiscal stimulus. finally, any increase in uncertainty about the longer - term trajectory of government borrowing could raise term premiums. of course, sustained changes in fiscal policy may have supply - side implications that affect the long - run level of potential output, and hence actual gross domestic product. except to the extent that these long - run changes alter the equilibrium real rate of interest, however, they have only minor implications for monetary policy. in the frb / us model, about 40 percent of households are estimated to be rule - of - thumb consumers, implying that they generally spend most of their current income. the remaining households are life - cycle consumers, implying that their spending decisions are influenced by their expected permanent income rather than their current income. however, these consumers are nonetheless relatively sensitive to expected changes in income over the next several years because they are assumed to discount future income at a high rate, reflecting its uncertain nature. these basic results are also borne out by simulations using the federal reserve staff's estimated dynamic stochastic general equilibrium ( dsge ) model of the u. s. economy, edo, and its calibrated multicountry dsge model, sigma. nontraditional monetary policies current economic and financial conditions have not only changed the potential effectiveness