Tyler Cowen points us to a nice paper by Emmanuel Farhi and Ivan Werning on multipliers. The authors had been good enough to send me a copy earlier, so I can respond quickly. The paper contains some neat analysis, but I just want to focus on one point that Tyler mentions, which may appear counterintuitive at first, but is in fact quite a simple idea. I then want to argue against the implications for the UK that Tyler draws.
The authors focus on the ‘consumption multiplier’, which is the impact of government spending on consumption. So in a closed economy a consumption multiplier of zero is a government spending multiplier of one (there is no capital). This point is not clear from Tyler’s post.
As I have discussed before, and various papers by Eggertsson and Woodford (among others) have explored in detail, at the zero lower bound the consumption multiplier can be positive because higher output raises inflation which reduces real interest rates. The point the authors make is that the further into the future the increases in government spending are, the more powerful is this effect (as long as the zero lower bound constraint is still there). This may seem odd, but it follows simply from the properties of the New Keynesian Phillips curve.
Suppose I can increase output today or tomorrow. The New Keynesian Phillips curve basically says inflation today depends on expected inflation tomorrow and the output gap today. Additional output tomorrow will raise inflation tomorrow. However it also raises inflation today because it raises expected inflation. Higher output today only raises inflation today. So for given nominal interest rates, higher output tomorrow gives me two periods of lower real interest rates, while higher output today just gives me one. A one-off addition to government spending tomorrow, because it raises output tomorrow, gives me a greater impact on real interest rates and therefore consumption than the same one-off increase in government spending today.
Does this have any new implications for the debate of UK austerity? I see things very differently from Tyler. Let’s take his initial points in turn.
- This is where the confusion over the output and consumption multiplier comes in. Suppose we are highly uncertain about the impact fiscal or monetary policy has on inflation right now. That makes monetary policy’s impact very uncertain, but with government spending on domestic goods you get an output multiplier of one for sure.
- Again, this is the inflation effect, where fiscal tightening reduces inflation, which at the zero lower bound raises real interest rates, leading to an appreciation. However, as Tyler notes, at the same time as 2010 austerity we also had positive inflation shocks. Furthermore, we have little idea of what caused the 2008 depreciation. So movements in the real exchange rate are not a very reliable indicator of anything.
- I’m not quite sure what advice is being referred to here. What I would take from the timing point discussed in the paper is that you cannot ignore the impact that announcements of future austerity can have on output today. Expectations matter in macro. Those who say most of the cuts have not happened yet so they cannot explain weak UK output ignore this point. What opponents of austerity like me have been arguing for is postponing cuts until a recovery eliminates the zero lower bound constraint. Without that constraint, monetary policy can in principle completely offset the impact of any cuts on output.
- Not guilty – indeed I have stressed how price stickiness is not the issue at the zero lower bound.
- Again not guilty – indeed this cannot apply to anyone who uses New Keynesian theory, as the New Keynesian model is an elaboration of the RBC model.
I’ll stop there, except to make two comments. First, the conclusion that Tyler draws just does not stand up. The paper by Farhi and Werning, like much of the literature that this paper refers to, some of which I have talked about before, uses fairly standard New Keynesian models. New Keynesian models imply cuts in government spending reduce output at the zero lower bound. My discussion of this has been as transparent as I can make it. I also take great exception to the implication in (5) that I pick and choose which theory I use in order to support a particular policy position.
Second, there is a lot more that is interesting and important in the Farhi and Werning paper, particularly concerning policy in a monetary union, and I hope to talk about that in a later post.