How large is the Keynesian fiscal multiplier?
Recently Greg Mankiw (whose Macroeconomics text is widely revered by econs undergrads) wrote a post on his blog which highlighted two papers (both published this year) concerning the size of the Keynesian spending multiplier. Those who have studied Econs 101 know that when a dollar is spent, the total cumulative effects of that spending on the economy and GDP is more than just a dollar. Since I’m lazy, I’ll just let Wikipedia do the explaining.
But I’ll sum it up as this: A dollar’s worth of federal spending means that one dollar ends up in the pocket of private contractors who would spend some of that money to pay their workers and suppliers who would in turn pay their workers/purchase consumer goods, and in turn some of this money spent would end up in another consumer’s pocket, effectively increasing the flow of money. The cumulative and diminishing effects of this spending results in a uptick in aggregate demand, and since a recession is caused by lackluster demand, this helps revive the economy.
The multplier is a major reason why Keynesians advocate fiscal stimulus spending to drag moribund economies out of recession; spending by the federal government starts off higher in the “money chain” compared to private spending.
That’s for the background. Back to the gist of the post. Mankiw noted that two similar models of Keynesian economics yielded very different estimates of the multiplier even though both assume a near-zero interest rate environment:
Lately, Paul Krugman has been dissing modern macroeconomics, mainly because many macroeconomists do not agree with his conclusions about fiscal policy. This new paper by Marty Eichenbaum, Larry Christiano, and Sergio Rebelo should, however, make Paul happy. They report large fiscal policy multipliers in a new Keynesian DSGE model when the economy is at the zero interest lower bound.
An open question: How can the results in this paper be reconciled with results by John Cogan, Tobias Cwik, John Taylor, and Volker Wieland, who seem to perform a similar policy simulation in a similar model but reach a very different conclusion? Are there subtle differences in the models? Or subtle differences in the policy experiments? Or did one team simply make a mistake of some sort?
Figuring out why these two prominent teams of researchers come to opposite conclusions about fiscal policy multipliers, and which conclusion is more applicable to actual policy, would be a good paper topic for an ambitious grad student.
Following that Brad Delong weighs in with a post, explaining that the latter paper which predicts a small multiplier effect assumes the principle of Richardian equivalence holds. For the former an expected deflationary environment artificially inflates real output, leading to much larger multiplier estimates.
Paul Krugman who was mentioned above by Mankiw, felt compelled to respond a day after Delong. The gist of his post is similar to Delong’s, except he makes it more explicit and less technical. Now the question that we should be asking is: Which model is more accurate?
Well if heavy-weight economists don’t have a definitive answer to that, I don’t think I can come up with one. But this should underscore the importance of implicit assumptions. Two similar models operating under near-identical monetary conditions reaches very different conclusions, both entirely due to distinct assumptions on consumer behaviour. You can have fancy models and complicated maths to back your theories up, but tweak some assumptions and you can change the outcome drastically (sometimes to reach a pre-conceived conclusion, but that’s another story).