This is a difficult topic to write about. The reason is simple- the issue of fiscal stimulus is extremely contentious and there is really no one way of determining the impact of fiscal policy. There is widespread disagreement over what is the optimal fiscal response. The majority of economists believe the fiscal stimulus plan is needed, but some vouch for increased Government spending on G&S, and some vouch for tax cuts. The Obama plan takes a bipartisan approach by including a $750 B package, of which 60% is government spending on infrastructure and ‘shovel ready’ projects, and the remaining in the form of a cut in payroll taxes and an increase in business tax credits (ie transfers to businesses), and transfers to low-income earners.
Before going onto the debate over the structure and size of the stimulus, a good starting point is to look at extreme scepticism over the stimulus. I think it is best if we begin by looking at the conservative extreme- that fiscal policy has no effect on output. This view has been in circulation since the 1930s, and is known as the treasury view. Its origins is in the advent of the Great Depression in Great Britain, when the treasury felt that funds will be displaced by the Government dollar for dollar with reduced investment spending, essentially a complete ‘crowding out’ effect of investment occurs. Also, it included the ideas of how any infrastructure spending would occur with a time lag, and that the increasing National debt may make it harder for Britain to maintain the gold standard (As increasing debt requires the running of Balance of Payment Deficits- which must be financed by making transfer payments to overseas).
It is interesting that even now a slightly revised form of the Treasury view is being put forward-primarily by Chicago school economists such as John Cochrane and Eugene Fama. Eugene Fama has attempted to use the National Product Income Accounts equation:
I = HS + CS + GS
As an identity that must always be satisfied in the National accounts. However, he then makes an unjustified assumption that HS (Household/Private sector savings) is invariant to changes in GS (Government Savings). Consequently, he says, that any reduction in GS must be offset by an equal reduction in Investment. From this initial standpoint, let me devise a framework of analysis of this assumption, and its implications. Firstly, why is HS invariant according to Fama, and, is there a case for HS to increase? Secondly, does Ricardian Equivalence matter for Fama’s thesis? Thirdly, doesn’t the current recession have characteristics that put fiscal policy in a brighter light than in previous cases, even despite problems in its productivity, welfare costs, and timing? Fourthly, doesn’t the current policy of 0 interest rates accommodate expansionary fiscal policy- and prevent a crowding out of private investment as such? Note that these three questions are somewhat intertwined and I will be reflecting on similar issues throughout my analysis.
Firstly, Fama believes that HS is invariant…but is there a case for HS to increase?
The point, mentioned above, that is the debate of this question is that Fama uses the identity as proof of “that any reduction in GS must be offset by an equal reduction in Investment”. This is a highly speculative suggestion with no model shown to prove such a binding constraint.
Let us begin by looking at Fama’s thesis in light of IS-LM analysis. One analysis that gives the same outcome as Fama is to assume a 0 interest elasticity of money demand. This can be shown using the LM equation
A 0 interest elasticity of money demand, c2, implies a vertical LM curve. Looking at a fiscal stimulus via an IS curve shift, 
It is clear that there is a complete crowding out of private investment. The story is simple. An IS curve shift raises income from A to B, at a constant interest rate i0. However, at pt B, we can clearly see an excess demand for money. With constant money supply, money demand must reduce via high interest rates. With low interest rate elasticity of Money demand, the interest rate needs to be raised an exorbitant amount, enough to induce a complete crowding out of investment as the economy comes to equilibrium at pt C, at pre-stimulus income. Thus the same outcome is reached, but via a completely different analysis to Fama. Fama did not acknowledge such a model, and if anything such parameters as interest elasticity of money demand need to be empirically proven.
There is ample reason to believe that the interest elasticity of money demand is more likely to be very high; infinite. This is because in liquidity trap the LM curve is flat, as at a 0 interest rate money demand is perfectly elastic with respect to the interest rate. Why? Because open market operations result in substituting T-bills for cash, but with 0 interest rates they are perfect substitutes, and people should not care whether they hold cash or treasury bills at a 0 interest rate. This has an important implication for increases in money demand, as an increase in money demand is always satiated at a 0 interest rate. Using the same diagrammatic IS-LM analysis as above:
Note the stark contrast, in that the shift of the IS curve produces a shift in the money demand curve, but it is still elastic at a 0 interest rate, meaning that it is satiated at a 0 interest rate. Thus this case can be seen as a fully accommodative monetary policy, and is a more plausible scenario with the Federal reserve having a current policy of a low structure of interest rates until inflation picks up, it is likely that any fiscal stimulus will accompany near 0 interest rate for quite some time. Note that the nature of financing the stimulus is important, and bear in mind that if the fiscal stimulus involves no real financing but rather monetisation, then there will be an eventual crowding out of investment as interest rates respond to the inflation. The main point of this exercise is to show that the IS-LM model can show 2 opposing cases based on the estimate of a single parameter- interest elasticity of money demand, and that the latter scenario shows that investment is likely to increase, given the constant interest rate and increased income.
Now I want to show whether Fama’s main thesis, of whether HS is invariant, holds. One extreme, advocated by both Brad Delong and Andy Harless, is that a Keynesian effect of increased government purchases on the deficit is ‘self-financed’ by the increased savings due to the multiplier effect. In other words, if there is a tax rebate, and one was to spend it. One will find that the continuum of spending, that is, the fact that your spending leads to another person’s income- some of which is spent and saved- after infinite rounds the cumulative savings of all the rounds hence will be equal to your consumption. Therefore by this multiplier effect a deficit is self-financed via the increased savings, and has the implication for NPIA equation of leading to an offsetting increase in HS to a reduction in GS- with Investment constant. Note that this Investment constant makes more sense in a liquidity trap situation, as interest rates are rigid at 0. Though real interest rates can change via deflation, keeping investment unchanged has this useful property of increased income, increased private savings, which makes the fiscal stimulus as empowering as can be (also with interest rates fixed the crowding out effect is negligible). What Harless and Delong refer to is in fact the simple, fixed price Keynesian model, as shown below:
Note that we have two equilibriums, from which we can derive as follows:
S=I+G-T is 1st equilibrium equation
S+deltaS = I+deltaI+G -T is 2nd equilibrium equation
Substituting for S in the 2nd equation gives
I+G-T+deltaS = I+deltaI+G-T simplifying to
deltaS=deltaI
This model gives the interpretation that government purchases is effectively financed by a corresponding increase in private savings, with the implication that reductions in government saving are fully absorbed by an increase in private saving. Note that this model has spurious assumptions that give it a maximum multiplier effect, namely, the investment being autonomous and the fixed price level.
The multiplier effect has most relevance when it utilises idle resources. The above model illustrates one way in which idle resources enable government purchases, by reducing inventory accumulation it enables increases in private investment and income as the reduction in inventories is a signal to producers to increase production. Delong describes this argument as, under the condition of below full employment and with idle resources, fiscal policy can expand output as
"Increases in government spending lead to unexpected declines in inventories and unexpected declines in inventories lead firms to expand production, which leads to increases in income and saving"
A simple Keynesian diagram can show this
The shaded area represents a demand exceeding supply- showing declines in inventory accumulation, which trigger employment as firms capitalise on the demand. This employment will increase income, leading to further demand, further declines in inventories and so on until unwanted inventory accumulation is 0, at full employment income. Now, this model is unrealistic as
i) Inventory levels are nearly always +ve
ii) Inventory levels do not comprise such a large portion of idle resources- nor is it the only indicator to firms of demand
iii) The fact that the model assumes that a period of declining inventory accumulation corresponds to a period of excess demand- when the reality is insufficient demand which can only be somewhat mitigated by government purchases
But it captures the intrinsic link between the Keynesian model and its relevance when there is a ‘stock overhang’ or idle resources, brought about by insufficient demand.
Thus the Keynesian approach is to admit to the truth of the accounting identity, but it emphasises a behavioural relationship to enable adjustment of any imbalance that occurs in the accounting identity. And, as stated before, the behavioural relationship is to make income an endogenous variable, which adjusts to make savings=leakages. From Krugman’s blog, a nice diagram is:
Note that this is different to the prior model, as it treats taxation as an endogenous variable- a more realistic assumption
“After a change in desired savings or investment something happens to make the accounting identity hold. And if interest rates are fixed, what happens is that GDP changes to make S and I equal.” (Krugman)
Note that an upward shift in I+G will simply increase savings and taxation revenue via increased income. Thus we have a situation where, to make investment constant (as implied by the model), we have offsetting increases in private sector savings, and through the concept of ‘dynamic scoring’ (explained in subsequent section), a partial recovery of the increase in deficit through increased taxation revenue (ie some recovery in public savings). This is the essence of arguments put forward by Harless, Delong and Krugman. The only problem of course is that this model disregards the interest rate, and assumes fixed prices. Consequently the ‘crowding out’ argument of how increased supply of treasury bonds lowers its price and raises the interest rate- as it competes for funds- has no meaning in this model- as investment is irrevocably fixed. That is why these economists claim that the Keynesian emphasis has more relevance in circumstances where the interest rate is fixed at the lower bound, and, though prices are not fixed in reality, upward pressure on prices can be very stabilising at this point. Even if this model does not hold true, Krugman makes the point that Fama should not take an accounting identity as the means of proof, and he should go about proving the behavioural relationships associated with how income, private savings and even the money supply (to be discussed later) changes in response to a change in government savings. In conclusion, the Fama’s second dictum
“If the financing takes the form of additional government debt, the added debt displaces other uses of the same funds”
Is wrong because savings is not a fixed quantity; it is an endogenous variable.
The treasury view is in fact invalidated by the basic logic that, if one can argue Government projects are always displaced, and then Investment projects are equally invalid, as they need financing, they use funds, and they may not necessarily be more productive. Thus any of the events in which economic growth has been stagnant, or economic growth has skyrocketed are just pure coincidences rather than a more pragmatic reflection of the fact that multiplier effects do exist. In other words, if Private investment can have a multiplier effect on the economy, as we have seen in bubbles (which are essentially over investment), then so can Government spending!
Secondly, does Ricardian Equivalence matter for Fama’s thesis?
The theory of Ricardian equivalence is seen as irrelevant to Fama’s argument. This theory is described well by Menzie Chinn:
“When budget constraints hold with certainty intertemporally, and there is no way to default even partially on government debt (say via unexpected inflation), then increases in government debt due to tax cuts (for instance) induce no change in current consumption because households fully internalise the present value of the future tax liability”
Another way to explain ricardian equivalence is to claim that any reduction in GS is offset by an equal increase in PS. Under this, investment does not change, but consumption falls by enough to maintain aggregated demand at the level prior to an increase in the deficit. The idea is that, when given a tax cut, consumers realise that the need to finance debt causes the Government to sell bonds equal in net present value to future tax liabilities. This means the purchasing of bonds by the private sector represents the increase in private sector savings- and with unchanging consumption- to hold the intertemporal budget constraint. This view also makes the deficit ‘self-financing’, but rather by constant C and constant AD, with savings being reallocated from Government to the private sector.
Fama says that, suppose Ricardian equivalence does not hold true (a good assumption, as it is empirically false). Then suppose that the lower taxes lead to a consumption equal to the increase in government debt required to finance lower taxes (the ‘what you give with one hand, you take with the other’). Then, all that occurs is a compositional change, with the increase in consumption from the tax cut offset by a reduction in investment.
Both arguments can be invalidated. Firstly, Ricardian equivalence has differing effects, depending on whether the deficit is via increased government purchases or tax cuts. There is a fundamental difference, because with increased government purchases, current disposable income of households has not changed. This means Ricardian equivalence would imply that there is an offsetting reduction in consumption as households reallocated their budgets in light of future taxes. However, with the example provided in Econospeak, suppose a $100B investment is financed through treasury debt at a 5% interest rate. Then, if the budget constraint holds, we expect a permanent increase of $5B in taxes each year henceforth. Thus with rational expectations we expect consumers to reduce their consumption by $5B. Thus in the 1st year there is an increase in aggregate demand of $95B. Notice that with RE applied to taxes- we see no effect simply because the entire amount is saved- not altering current consumption. In this case, we are seeing purchases occurring, with only a minor offset in consumption. Thus the multiplier effect has much more meaning for government purchases, and through increases in income, private savings increase as well as increased taxation revenue can mitigate any potential fall in investment.
The second idea, of how if an entire tax cut is consumed, then the reduction in total savings leads to a corresponding decrease in investment- is yet again assuming that future debt burdens lead to a displacing of funds which could be used for private investment or simply consumption (As if consumers reject saving for future tax liabilities now, they simply have to save more later). The problem of course rests again on the fact that, as consumption increases for this year, there will likely be an increase in velocity, where the consumption leads to increases in income, that lead to increases in consumption, and so on, which means that the budget deficit has recovered, resulting in less ricardian taxes in the future. Thus the dynamic effects of consumers delaying savings mean that the theory of ricardian equivalence is distorted by the theory of dynamic scoring (Will be explained in more depth in a future post).
Thirdly, doesn’t the current recession have characteristics that put fiscal policy in a brighter light than in previous cases, even despite problems in its productivity, welfare costs, and timing?
The trick is to recognise that the policy of 0 interest rates and the fact that we are far off from full employment are the differences between now and previous recessions (notably the 1982 Volcker ‘Disinflation’). What this means is, well, since conventional monetary policy cannot tame the business cycle, then fiscal policy comes to the fore. Another advantage from Government stimulus is that there is little chance of inflationary expectations from developing, and the social cost of government spending is far less than its social benefit when the economy is below full employment (According to Krugman). Krugman’s idea is that with economy below full employment, and an inability to achieve negative nominal interest rates, the only way in which demand can be sustained to production is via increased government purchases. This compensates for the disutility of extra work effort- a direct implication of increased G, a factor that raises the eyebrows of conservatives who believe increased work effort is not necessarily the correct way for a fiscal stimulus to be effective.
The essence of the 2nd question relies on idle resources. Despite the lack of consensus among economists like Fama and Delong, they both agree that projects for public goods that the private sector cannot produce, and public goods that have positive externalities and pass the cost-benefit test should surely be enacted. Fama is afraid that the ‘S-Word’, Stimulus, will lead people to believe that any projects, even non-productive ones- will do. He is afraid that interest groups and political pork will cause the $850B to be misused and highly inefficient, and will disobey his dictum:
“Stimulus plans only enhance incomes when they move resources (by absorbing savings that could otherwise finance private investment) from less productive to more productive uses”
Despite the acknowledged existence of idle resources, accumulated inventories only add up to $47B. Thus the earlier argument of Delong suggesting that reductions in inventories or unwanted investment will lead to increases in saving and income, is mitigated by the fact that only $47B of unwanted investment can be ‘replaced’ by roughly $500B of government purchases (disregarding tax cuts), with $453B more unproductive private activities to displace. Kevin Murphy from Chicago also believes the extent of idle resources is small, given 93% of the labour force is employed, and believes that any stimulus package will result in the use of these non-idle workers.
An interesting change in the Keynesian theory is regarding the welfare effects of increased government spending. Keynes, in the general theory, claimed that to prop up demand a cost-benefit test need not be passed, even a ‘bridge to no-where’ (though he in fact used the example of storing bottles of cash underground and making people dig to obtain the cash as income) would do to prop up demand. However, Mankiw makes the point, that despite the increase in GDP that occurs as income is paid to the resources put into use in constructing the bridge to no-where, it is not welfare enhancing. A nice Mankiw post in which he highlights this social disutility is by taking Joe Average
a) Using tax rebate to watch favourite show
b) Employed by government to watch favourite show
c) Employed by government to watch hated show
Note that a) and b) are equal in welfare, but b) shows an increase in GDP. c) shows an increase in GDP but results in lower welfare than a). The moral of this is that government spending must pass the cost-benefit test, and that one good thing about tax cuts is that if consumers choose to spend it will be utility maximising, whereas government spending may not.
Krugman argues against stimulus sceptics by saying that firstly, the wedge between social benefit and cost of government spending is correlated to the wedge between employment and full employment. Secondly, he believes that the above argument of Mankiw’s does not apply because
“We’re talking about spending more on public goods: goods that the private market won’t supply, or at any rate won’t supply in sufficient quantities. things like roads, communication networks, sewage systems, and so on”
Social advantage of G at E
Krugman also believes that the cost-benefit analysis must take into account the fact that employment is below full employment. From the fact that
i) More Resources are immobilised or idle
ii) Private demand not responsive to Monetary policy, due to business uncertainty and the 0 lower bound
iii) With more idle resources and restrained demand, less displacement occurs and if anything the infrastructure provided will be able to kick-start investment rather than displace
Thus, by the above social benefit exceeding cost, from a welfare point of view it is advisable to increase G until the economy reaches full employment.
In conclusion to point 2, I am of the belief that fiscal policy is likely to have more short-run effect now than in any other time since the Great Depression. The fact that monetary policy is fully accommodative, and a flight to quality- to treasury debt- means that debt can be financed with ease in the short-run. As Cochrane says, the only plausible way in which aggregate demand can drop is for there to be a transfer from consumption and investment to holding cash or treasury debt-, which is what the flight to quality, represents. Thus the Government effectively escapes the ‘intermediation’ required to finance their spending- and is given, in a sense, a mandate to increase aggregate demand to full employment. Another obvious reason is the need to prevent a deflationary spiral (a point raised many times, particularly in ‘Monetary Policy Rules’) and to avoid the liquidity trap, where interest rates may not be low enough to stimulate investment, and there is lower interest rate sensitivity to investment (where low interest rates play a minor role in investment due to the loss of confidence, business sentiment in the future). All of these additional reasons point to fiscal policy coming to the fore in depression economics, and tends to mitigate the ‘cost-benefit’, welfare analysis of government spending, and minimises any ‘crowding out’ or simple reallocation of resources put forward by the Chicagoans.
Fourthly, doesn’t the current policy of 0 interest rates accommodate expansionary fiscal policy- and prevent a crowding out of private investment as such?
For third point, we have 0 interest rates, though according to a Goldman Sachs study the interest rate required to equilibrate money demand and money supply is –6%. This is a direct implication of the 0 nominal lower bound, and means that an above equilibrium interest rate translates to excess loanable funds- or as Andy Harless puts it, excess supply of money. This means that, given that a much lower interest rate is required to stimulate investment, at an above equilibrium interest rate there is a quantity of investment that is constrained.
Due to the excess supply of money/loanable funds, it can be loaned to the Government, which can insatiate itself with deficits without disturbing the money demand (demand for loanable funds) by private investors. It is only when the deficits reach a certain point where it does crowd out investment, but at that stage interest rates are raised due to full employment being reached. Note that I assume that the moment crowding out occurs corresponds to full employment- in other words, as long as there are idle resources then fiscal stimulus has no or little crowding out effect.
Another equivalent way of putting forward this argument is that the financial intermediation required to lend savings and finance private investment has been somewhat stemmed by the credit crunch. The Government can effectively ‘skip’ this intermediation via the financing of safe treasury debt at low interest rates, and with coordination from the central bank to maintain their fed funds rate no crowding out of investment (via interest rates) can occur.
The relevance of money supply is very important, and is the reason why Friedman felt that government policy is limited, as it does not necessarily affect the total quantity of money, which is the long-run determinant of growth. In ‘Comment on the critics’, a paper cited in Delong’s blog, Friedman says
“We may put this point differently. Assume a one-year increase in the deficit, with the budget then returning to its initial position. If this is financed by borrowing from the public with no change in monetary growth, then, in the most rigid Keynesian system, the IS curve moves to the right and then back again; real and nominal income rise for one year, then return to their initial values. If the one-year increase in the deficit is financed by creating money, the LM curve moves to the right as well, and stays there after the IS curve returns to its initial position. If prices remain constant, real and nominal income stay at a higher level indefinitely. If, as is more reasonable, prices ultimately rise, real income may return to its initial level, but nominal income will stay at a higher level indefinitely. Surely, to paraphrase a remark of Tobin's in another connection, the monetary effect is "alchemy of a much deeper significance" than the fiscal effect...”
Here he shows how it is in-fact the response of monetary policy that determines the long-run outcome of fiscal stimulus. Supposing the money growth is fixed, and then a one-year deficit will just raise incomes temporarily for the one year, until the deficit is reined in by the raised taxes/cut in Government purchases. However, if monetary policy is accommodative, then there will be a rightward shift of the LM curve, and a rise in nominal income. Whether there is a rise or fall in real income is dependent on whether there is a price adjustment, where the increase in money growth is likely to raise prices, which, in the ‘long-run neutrality of policy’ case leads to a real-income the same prior to the increase in the deficit. Note that this neutrality of fiscal policy on AD relies on 3 assumptions:
i) There is, at some point, a reduction of the deficit made to tie accumulated government purchases to accumulated tax revenue
ii) There is an accommodative monetary expansion, to maintain interest rates at roughly the same level
iii) The fiscal and monetary expansion will raise inflationary expectations- the price level and enable a return to the pre-fiscal real income.
Now, it is the third assumption that I feel is negated by the current scenario. Why? Inflationary expectations can only increase if the economy, prior to the stimulus, is equal or above full employment. This correlates with the natural rate thesis that inflation will always rise if unemployment is below the natural rate, until it equals the natural rate, and inflation will keep falling when the unemployment rate is above the natural rate. When an economy is at full employment, a fiscal stimulus may have short-run effects, but will always translate to creating inflation, and a return to pre-deficit levels of income. The reason is of course that the deficit cannot be accommodated by a monetary policy, if the monetary policy is presumably based on an inflation-targeting role.
We will now look at an AD-AS model explaining clearly what happens if fiscal policy is used when the economy is at full employment.
The AD and AS relations are:
AD: Y=Y (i(n) +a(P-P(t)),G,T)
AS: P=P (e)*F (1-Y/L, z)*(1+m)
Note that we are neglecting Friedman’s assumption of the deficit being financed by an offsetting surplus the next year, as this will complicate the above illustration too much.
The story above is simple to explain. Basically, the short-run effect of the fiscal stimulus is simply to raise income from Y Natural to Y1. Two things mitigate the multiplier effect:
i) The elasticity of the supply curve. Note when it is perfectly elastic, the Keynesian model applies (Where autonomous investment implies a vertical AD curve)
ii) The interest elasticity of investment. Note that the interest rate rule is i=i (n)+a (P-P (t)), therefore, once P-P (t)>0, i>i (n), then there may be some loss of investment. However, note that the investment function is likely to have sensitivity to income, and one must be agnostic as to the sign of investment change, simply because I=I (y, i), and the effects of income and interest rate counteract each other. However, since Y is at full employment prior to the stimulus, it is likely that there is little or no idle resources- and consequently the crowding out effect has more significance, and I is likely to reduce.
Now the 2nd effect is for the supply curve to shift up, which is a natural response on the part of producers, to raise their expectation of the price level, when the current price level is greater than the price level at full employment. The 3rd effect is for the fiscal stimulus to induce a change in monetary policy, where to obtain the price level the natural rate of interest must increase, shifting the AD curve back to the original, leading to a dynamic shift (as shown by arrows), back to the original point at full employment and at P=P (e)=P (t). Under this model, neglecting dynamic scoring, assuming C is constant than Investment must drop by the amount of the Government spending. Thus to maintain demand the crowding out effect is completed by Monetary policy- assuming of course that it is focused on a PLT rule. Given that Inflation targeting is simply a dynamic version of this model, the ultimate result of fiscal policy being neutral in aggregate demand but requiring offsetting investment would actually receive a majority consensus among economists.
Seeing that we are in a below full employment scenario, it is likely that all the fiscal stimulus would do is attempt to counter falling prices- and so, assuming it stabilises the price level, then rising nominal income will imply rising real income. More importantly, it prevents a deflationary spiral, and by reducing real interest rates will stimulate investment. Thus, using similar analysis, except with an IS-LM model, we can make the immediate assumption that the LM curve is horizontal (something Fama does not comprehend), as interest rates are rigid at the 0 bound.
In fact, Krugman describes this argument as ‘damnification’, of how there are actions that are taken that seem to be good but have extreme bad consequences. In this case, he uses the example of avoiding stimulus due to its burden on future debt as a ‘damnification’, because without the stimulus we are ever more likely to enter a deflationary trap, where deflation, together with the 0 lower bound, create not only debt deflation but result in very high real interest rates.
“Yes, the effects of fiscal policy are uncertain; yes, running up large debts is risky; but doing nothing is even riskier, because there’s a high probability that if we don’t act strongly deflation will get embedded in the economy. We may be damned if we do, but we’ll almost surely be damnified if we don’t”
Another equivalent way of putting forward this argument is that the financial intermediation required to lend savings and finance private investment has been somewhat stemmed by the credit crunch. The Government can effectively ‘skip’ this intermediation via the financing of safe treasury debt at low interest rates, and with coordination from the central bank to maintain their fed funds rate no crowding out of investment (via interest rates) can occur.
The relevance of money supply is very important, and is the reason why Friedman felt that government policy is limited, as it does not necessarily affect the total quantity of money, which is the long-run determinant of growth. In ‘Comment on the critics’, a paper cited in Delong’s blog, Friedman says
“We may put this point differently. Assume a one-year increase in the deficit, with the budget then returning to its initial position. If this is financed by borrowing from the public with no change in monetary growth, then, in the most rigid Keynesian system, the IS curve moves to the right and then back again; real and nominal income rise for one year, then return to their initial values. If the one-year increase in the deficit is financed by creating money, the LM curve moves to the right as well, and stays there after the IS curve returns to its initial position. If prices remain constant, real and nominal income stay at a higher level indefinitely. If, as is more reasonable, prices ultimately rise, real income may return to its initial level, but nominal income will stay at a higher level indefinitely. Surely, to paraphrase a remark of Tobin's in another connection, the monetary effect is "alchemy of a much deeper significance" than the fiscal effect...”
Here he shows how it is in-fact the response of monetary policy that determines the long-run outcome of fiscal stimulus. Supposing the money growth is fixed, and then a one-year deficit will just raise incomes temporarily for the one year, until the deficit is reined in by the raised taxes/cut in Government purchases. However, if monetary policy is accommodative, then there will be a rightward shift of the LM curve, and a rise in nominal income. Whether there is a rise or fall in real income is dependent on whether there is a price adjustment, where the increase in money growth is likely to raise prices, which, in the ‘long-run neutrality of policy’ case leads to a real-income the same prior to the increase in the deficit. Note that this neutrality of fiscal policy on AD relies on 3 assumptions:
i) There is, at some point, a reduction of the deficit made to tie accumulated government purchases to accumulated tax revenue
ii) There is an accommodative monetary expansion, to maintain interest rates at roughly the same level
iii) The fiscal and monetary expansion will raise inflationary expectations- the price level and enable a return to the pre-fiscal real income.
Now, it is the third assumption that I feel is negated by the current scenario. Why? Inflationary expectations can only increase if the economy, prior to the stimulus, is equal or above full employment. This correlates with the natural rate thesis that inflation will always rise if unemployment is below the natural rate, until it equals the natural rate, and inflation will keep falling when the unemployment rate is above the natural rate. When an economy is at full employment, a fiscal stimulus may have short-run effects, but will always translate to creating inflation, and a return to pre-deficit levels of income. The reason is of course that the deficit cannot be accommodated by a monetary policy, if the monetary policy is presumably based on an inflation-targeting role.
We will now look at an AD-AS model explaining clearly what happens if fiscal policy is used when the economy is at full employment.
The AD and AS relations are:
AD: Y=Y (i(n) +a(P-P(t)),G,T)
AS: P=P (e)*F (1-Y/L, z)*(1+m)
Note that we are neglecting Friedman’s assumption of the deficit being financed by an offsetting surplus the next year, as this will complicate the above illustration too much.The story above is simple to explain. Basically, the short-run effect of the fiscal stimulus is simply to raise income from Y Natural to Y1. Two things mitigate the multiplier effect:
i) The elasticity of the supply curve. Note when it is perfectly elastic, the Keynesian model applies (Where autonomous investment implies a vertical AD curve)
ii) The interest elasticity of investment. Note that the interest rate rule is i=i (n)+a (P-P (t)), therefore, once P-P (t)>0, i>i (n), then there may be some loss of investment. However, note that the investment function is likely to have sensitivity to income, and one must be agnostic as to the sign of investment change, simply because I=I (y, i), and the effects of income and interest rate counteract each other. However, since Y is at full employment prior to the stimulus, it is likely that there is little or no idle resources- and consequently the crowding out effect has more significance, and I is likely to reduce.
Now the 2nd effect is for the supply curve to shift up, which is a natural response on the part of producers, to raise their expectation of the price level, when the current price level is greater than the price level at full employment. The 3rd effect is for the fiscal stimulus to induce a change in monetary policy, where to obtain the price level the natural rate of interest must increase, shifting the AD curve back to the original, leading to a dynamic shift (as shown by arrows), back to the original point at full employment and at P=P (e)=P (t). Under this model, neglecting dynamic scoring, assuming C is constant than Investment must drop by the amount of the Government spending. Thus to maintain demand the crowding out effect is completed by Monetary policy- assuming of course that it is focused on a PLT rule. Given that Inflation targeting is simply a dynamic version of this model, the ultimate result of fiscal policy being neutral in aggregate demand but requiring offsetting investment would actually receive a majority consensus among economists.
Seeing that we are in a below full employment scenario, it is likely that all the fiscal stimulus would do is attempt to counter falling prices- and so, assuming it stabilises the price level, then rising nominal income will imply rising real income. More importantly, it prevents a deflationary spiral, and by reducing real interest rates will stimulate investment. Thus, using similar analysis, except with an IS-LM model, we can make the immediate assumption that the LM curve is horizontal (something Fama does not comprehend), as interest rates are rigid at the 0 bound.
Note that the IS shift has much more effect with accommodative monetary policy, and note that there is no reversion to the original level of income as monetary policy is fully accommodative (in any case, with employment below full employment the optimal level of inflation has not been reached). However, in the highly unlikely case of fiscal policy ‘over-inflating’, that is, shifting to IS 2, the prior ‘normal economy’ argument of how, with inflation/price level above target, the Central bank is required to raise interest rates, shifting the LM curve to LM 1 and reaching equilibrium at full employment- with a higher natural interest rate and higher price level. Therefore the only real worry, as Krugman points out, is fiscal stimulus not being enough, rather than fiscal policy ‘over-inflating’, as Monetary policy has the enormous advantage of reversing its path very quickly (a very small action lag, despite large recognition lags).
Let us analyse the above scenario in another perspective. Suppose monetary policy is designed to follow an inflation target. With inflationary expectations below the inflation target, a low structure of interest rates are required to attempt to anchor inflation to target (This is described in more detail in ‘Monetary Policy rules?’) Let us also assume that the inflation target corresponds to an economy that is more or less at full employment. Now the fiscal stimulus will, if anything, help in the process of reversing the falling inflation and try to increase inflationary expectations to a level closer to the target. Thus, we are likely to see no change in interest rates, as inflation has not over-shot its target in this case. Thus in this case the low price growth would enable rising real incomes. Now take the unlikely case of inflation overshooting its target- but by implication, the economy must already be at full employment, as an overshooting can only occur if the UE rate is below the natural rate. Subsequently, monetary growth is reined in to enable economy to return to full employment.
In other words, the price level does not prohibit the fiscal stimulus from having real effects, mainly because of the current destabilising effects of a falling price level, policies that aim to stabilise prices can do a lot of good, with the added benefit that these policies will not be as inflationary as in the case of an economy in more normal circumstances (with inflation at the target, and economy at round about full capacity).
Let us analyse the above scenario in another perspective. Suppose monetary policy is designed to follow an inflation target. With inflationary expectations below the inflation target, a low structure of interest rates are required to attempt to anchor inflation to target (This is described in more detail in ‘Monetary Policy rules?’) Let us also assume that the inflation target corresponds to an economy that is more or less at full employment. Now the fiscal stimulus will, if anything, help in the process of reversing the falling inflation and try to increase inflationary expectations to a level closer to the target. Thus, we are likely to see no change in interest rates, as inflation has not over-shot its target in this case. Thus in this case the low price growth would enable rising real incomes. Now take the unlikely case of inflation overshooting its target- but by implication, the economy must already be at full employment, as an overshooting can only occur if the UE rate is below the natural rate. Subsequently, monetary growth is reined in to enable economy to return to full employment.
In other words, the price level does not prohibit the fiscal stimulus from having real effects, mainly because of the current destabilising effects of a falling price level, policies that aim to stabilise prices can do a lot of good, with the added benefit that these policies will not be as inflationary as in the case of an economy in more normal circumstances (with inflation at the target, and economy at round about full capacity).
In fact, Krugman describes this argument as ‘damnification’, of how there are actions that are taken that seem to be good but have extreme bad consequences. In this case, he uses the example of avoiding stimulus due to its burden on future debt as a ‘damnification’, because without the stimulus we are ever more likely to enter a deflationary trap, where deflation, together with the 0 lower bound, create not only debt deflation but result in very high real interest rates.
“Yes, the effects of fiscal policy are uncertain; yes, running up large debts is risky; but doing nothing is even riskier, because there’s a high probability that if we don’t act strongly deflation will get embedded in the economy. We may be damned if we do, but we’ll almost surely be damnified if we don’t”
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