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How large is the Keynesian fiscal multiplier?

with 6 comments

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).


Written by defennder

July 15, 2009 at 3:44 PM

6 Responses

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  1. There is no multiplier. Its all rubbish. Its pulling the bunny out of the hat. The spending is just redirected from business-to-business spending where it isn’t picked up by GDP….. and sending it over to consumer or government spending where it is picked up by GDP.

    So its just a sleight-of-hand. And actively harmful to authentic recovery.


    July 17, 2009 at 8:20 AM

  2. Hi graemebird,

    Thanks for reading and commenting. That’s basically how money flows in the household-firm-markets relationship. In a recession, spending is cut and the flow slows to mere trickles.

    The point is, if no one spends GDP falls because spending, be it private or government is part of GDP. Factories won’t churn out metal girders when no one wants to build railways and houses. Churning out metal girdles involve paying workers to do so who would spend some of that income on goods. The total output isn’t just girders. It’s girders plus consumer goods bought. GDP increases by both government spending and consumer spending. How is that not a mutiplier effect?

    Just ask yourself this question:
    Isn’t electricity a scam? Every electron the power station sends to you, you send one back. We don’t accumulate electrons anywhere. Why the hell are we paying for power then?


    July 18, 2009 at 4:15 PM

  3. But increasing Government spending DOES NOT increase spending overall. Only that spending associated with GDP.

    It simply redirects spending from where it isn’t picked up in GDP, to where it is picked up in GDP.

    This is the important point. To say that increasing government spending would increase spending overall is a superstition.

    GDP = C + Net I + G + X – M

    But this is no measure of spending. It doesn’t include that area of spending that we really need to know to get out of the recession. To get out of a recession we want to cut out resources frittered away in consumption and government spending and increase spending on GROSS investment.

    Gross Domestic Revenue= C + GROSS I + G + X – M

    Gross investment turns out to be all productive expenditure. All business spending. All this Keynesian vandalism turns out to be is the redirecting of resources from gross business spending to consumer spending by individuals and taxeaters.

    Its one of the most harmful scams ever invented in history.

    There is one way and one way only to increase total spending and that is via monetary policy. Fiscal policy is never stimulatory since it does not increase spending.


    July 18, 2009 at 11:51 PM

  4. Perhaps you’ll like to give an example of spending which isn’t recorded in GDP? Because this seems to be your central argument:

    Government spending displaces an equal amount of spending which does not factor into GDP. The government spending is then reflected into GDP. So in totality including non-GDP spending, nothing has changed.

    It’s odd you claim that we need to increase gross investment. Because some time back I recall the stimulus package passed by Congress was watered down due to “wasteful spending”. Somehow investments in tangible and lasting fixed assets such as highway infrastructure, buildings, you know, the shovel-ready projects doesn’t count?

    And in case you’re wondering business spending is decreasing. Why? Because of a continuous fall in consumer demand. Don’t take my word for it, read the WSJ:

    Corporate spending is expected to be constrained or reduced through 2010, which will perpetuate the weakness in the broader global economy. The gloomy outlook by Fitch highlights how the U.S. economy has several hurdles to clear before a turnaround after being crushed by a steep recession.

    For the second quarter, Fitch said while many companies will show improved sequential operating performance, the growth could be attributed to re-stocking of inventories rather than from a fundamental improvement from underlying demand.

    You need demand to pick up. Businesses don’t spend (ie. expand output) because they can’t get loans from banks on favourable terms and becaue they see no consumer demand for their goods. Spending is stimulus, government spending is spending.

    And I don’t see why brought up monetary policy. What hasn’t the Fed done enough of already? They’ve been printing money and extending loans to non-bank institutions and we’re still stuck in a recession.


    July 19, 2009 at 9:40 AM

  5. Business spending is falling as a result of

    1. Monetary factors which reduce total spending.

    2. Policy. Policy is taking spending away from business spending and putting it in government spending and consumer spending.

    And example of spending that doesn’t show up in GDP? Virtually all spending doesn’t show up in GDP. I work for a business that buys from other businesses and sells to other businesses. Hence almost none of our activity shows up in GDP.

    “And I don’t see why brought up monetary policy. What hasn’t the Fed done enough of already? They’ve been printing money and extending loans to non-bank institutions and we’re still stuck in a recession.”

    The fiscal side of things is keeping them in recession and will continue to do so. The Feds have been conspiring with the treasury to steal vast amounts of money and give it to the banks. Out of the monetary policy they have been using only some of it is legitimate. Certainly increasing the monetary base was legitimate. But all the thieving and subsidies to the banks are not. Paying interest on bank deposits with the Fed is a subsidy. And one which discourages lending. Giving low interest loans to banks is a subsidy.

    Cash injections through retiring debt is what was required. This and nothing else more than a RAR to make sure the extra cash needed didn’t lead to too much pyramiding and overshoot.

    Its by no means a mystery why a small amount of base money creation wasn’t going to do the job. Since the banks had pyramided 100 dollars of money supply on maybe as little as 3 dollars cash. If the money supply is about to collapse you might double or triple the monetary base under those conditions and still not solve the problem. But fiscal policy can only make things even worse and obviously so.

    Surely you can see that if you have only 3 dollars cash in comparison to 100 dollars money supply that a collapse would require vastly more cash to make sure the job was done????

    Nothing could be easier to understand then this. Some people assume that since that extra cash could lead to inflation its not a good option so fiscal policy ought to be turned to . This is straight irrationality as fiscal policy does not increase spending.

    So the idea is to use FISCAL TRIAGE, combined with cash creation through debt retirement, combined with a reserve asset ratio to stop the spending target from being overshot.

    Graeme Bird

    July 20, 2009 at 1:10 AM

  6. “You need demand to pick up. Businesses don’t spend (ie. expand output) because they can’t get loans from banks on favourable terms and becaue they see no consumer demand for their goods. Spending is stimulus, government spending is spending…”

    Lets go over it again. Government spending is not stimulus. Thats straight irrational fallacy. Government spending doesn’t increase total spending. It merely shifts that spending away from business-to-business spending. Which is where the resources need to go to end the recession.

    When the government spends it takes money from taxation or borrowing. Borrowing from the central bank is not fiscal policy. Its monetary policy. And if the government borrows from other sources there is no increase in nominal spending. Only the sucking of that spending away from where it would end the recession.

    Graeme Bird

    July 20, 2009 at 1:16 AM

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