| Summary: | We develop a general theory of state-dependent fiscal multipliers in a framework featuring two empirically relevant frictions: idle capacity and unsatisfied demand. Our key novel finding is that the <em>source of fluctuations</em> determines the cyclicality of multipliers. Policies that stimulate demand, such as government spending, have multipliers that are large in demand-driven recessions, but small and possibly negative in supply-driven downturns. Conversely, policies that boost supply, such as cuts in payroll taxes, are ineffective in demand-driven recessions, but powerful if the downturn is supply-driven. Austerity, implemented by a reduction in government consumption, can be the policy with the largest multiplier in supply-side recessions and demand-driven booms, provided elasticities of labor demand and supply are sufficiently low. We obtain model-free empirical support for our predictions by developing a novel econometric specification that allows to estimate spending and tax multipliers in recessions and expansions, <em>conditional</em> on those being either demand- or supply-driven.
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