Young Economics.

The Fiscal Policy Multiplier

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Greg Mankiw points to an interesting new paper by Christiano, Eichenbaum, and Rebelo (henceforth CER) on the fiscal policy multiplier.  They examine a New Keynesian macro-model under circumstances in which the zero lower bound on the nominal interest rate is binding, and they find that “the government spending multiplier is much bigger than one” (emphasis theirs).  From the introduction:

[W]e consider an economy with Calvostyle pricing frictions, no capital, and a monetary authority that follows a standard Taylor rule. [A shock to the discount factor] increases desired savings. … [W]hen the shock is large enough, the zero bound becomes binding before the real interest rate falls by enough to make aggregate savings zero.** The only force that can induce the fall in saving required to re-establish equilibrium is a large transitory fall in output.

The fall in output must be very large because hitting the zero bound creates an economic meltdown. A fall in output lowers marginal cost and generates expected deflation which leads to a rise in the real interest rate. This increase in the real interest rate leads to a rise in desired savings which partially undoes the effect of the fall in output. As a consequence, the total fall in output required to reduce savings to zero is very large. This scenario captures the paradox of thrift originally emphasized by Keynes (1936) and recently analyzed by Krugman (1998), Eggertsson andWoodford (2003), and Christiano (2004). The government spending multiplier is large when the zero bound is binding because an increase in government spending lowers desired national savings and shortcuts the meltdown created by the paradox of thrift.

** (Note that they are describing a model with no capital accumulation.  That’s why aggregate savings have to be zero in equilibrium.  They get all the same results in an extended model with capital and real rigidities, except that the zero lower bound on nominal interest rates becomes less likely to bind; it takes a larger shock to get into those circumstances, but once there, the effects on the fiscal multiplier are the same as in the no-capital model.)

As Mankiw notes, these results are quite different from those of another recent paper by Cogan, Cwik, Taylor, and Wieland.  Their estimates — also from a New Keynesian model — put the fiscal multiplier at approximately one on impact and declining dramatically in subsequent periods.  See the second row of estimates in the table below:


Note: The pertinent estimates are those in the Smets/Wouters row.

Why the dramatic differences between the results of these two studies?  In my quick reading of the papers, I noticed two things:

  1. The study by Cogan et al. is an empirical one.  They compute data-based estimates of the impact of actual projected spending by the US government.  CER, on the other hand, do a purely theoretical exercise.  They just derive dY/dG and assume some reasonable parameter values.
  2. CER actually model the economic shocks that drive the nominal interest rate to zero, and that shock (which they model in several different ways) itself affects the fiscal multiplier.  It’s not exactly clear what Cogan et al. do since they don’t describe their simulation procedure, but from what I gather, they simply assume that the central bank holds the nominal rate at zero for a set period of time — irrespective of real economic conditions — and then switches to a standard Taylor rule.  In CER’s paper, the monetary authority is always following its policy rule; economic conditions force it to set the rate to zero.

Given the current real-world importance of fiscal policy, the conflicting results from different sets of eminent macroeconomists is frustrating.  I don’t know how to choose between the two studies.  Perhaps the Cogan et al. approach is more likely to be empirically relevant because it’s based on actual government spending data?

Stimulative fiscal policy is controversial among economists.  The fact that the US economy continued to worsen after the passage of the Obama stimulus bill is consistent with two conceptual frameworks:

  1. See?  Stimulus doesn’t work.
  2. Things would have been much worse without the stimulus.  A bigger stimulus would be helpful.

I think it’s too early to jump to either conclusion yet — but then, one of the criticisms of fiscal policy is that it’s so slow.  But in any case, the controversy is rooted in the fact that we don’t know what we should expect to happen.  I don’t think, as some often seem to, that this means that the past 30 years of macroeconomics have been a waste.  For some reason that historians of economic thought will have to explain, economists have been obsessed with monetary policy; we know less about fiscal policy because far fewer people bothered to study it.  When the financial crisis and the subsequent recession happened, economists were ready with plenty of weapons from the monetary policy literature.  Ben Bernanke has basically implemented a lot of ‘unconventional monetary policy’ ideas from his own academic research.

But when people ask “What should we do to fight a recession?” what they really mean is “What should the government do?”  That means fiscal policy, and economists’ public credibility takes a hit because we have less to say about what the government should or shouldn’t do.

I’m sure that the next five or ten years will see a huge amount of energy spent on the study of fiscal policy.


Written by Alex

July 12, 2009 at 11:46 pm

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