Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday, 27 July 2014

Understanding fiscal stimulus can be easy

There seems to be a bit of confusion about fiscal stimulus. I think most people understand what is going on in undergraduate textbook models, but some seem less sure of what might be different in more modern New Keynesian models. This seems to revolve around three issues:

1) In Traditional Keynesian (TK) models any fiscal giveaway seems to work, whereas in New Keynesian (NK) analysis the type of fiscal policy seems to matter much more.

2) Is the dynamics of how policy works different in TK and NK models?

3) In TK models fiscal and monetary policy seem interchangeable, but NK models imply fiscal policy is a second best tool. Why is that?

In this post I will just cover the first two issues.

The best way to answer these questions is to ask how NK models differ from TK models, and where this matters. To keep things simple, let’s just think about a closed economy. I’ll also assume real interest rates are fixed, which switches off monetary policy. This is not quite the same as fiscal policy in a liquidity trap, because expected inflation may change, but that is a complication I want to avoid for now.

First, a difference that does not matter much for (1) and (2). The most basic NK model assumes the labour market clears, while the TK model does not. I tried to explain why that was not critical here.

The difference that really matters is consumption. In TK models consumption just depends on current post tax income, while in the most basic NK model consumption depends on expectations of discounted future income, and expectations are rational. This makes NK models dynamic, whereas in the textbook TK model we do not need to worry about what happens next.

This immediately gives us the best known difference between NK and TK: Ricardian Equivalence. A tax cut today to be financed by tax increases in the future leaves discounted labour income unchanged, and so consumption remains unchanged. However this is only a statement about tax changes. Changes in government spending have much the same impact as they do in TK models.

In particular, if we have a demand gap of X that lasts for Y years, we can fill it by raising government spending by X for Y years, and pay for it by reducing government spending in later years. A practical example of what I call a pure government spending stimulus would be bringing forward public investment. As taxes do not change, then for given real interest rates consumption need not change.

Nick Rowe sets up a slightly different problem, where there is a wedge shaped gap to fill. In that case government spending can initially rise, but then gradually fall back, filling the wedge. Same logic. Nick says that a policy that would work equally well in theory is to initially leave government spending unchanged, but then let it gradually fall, so that it ends up permanently lower. This is not nearly as paradoxical as Nick suggests. By lowering government spending in the long run, taxes will be lower in the long run. Consumers respond by raising consumption now and forever, so it is consumption that fills the gap. It works in theory, but may not in practice because consumers cannot be certain government spending will be lower forever. It is also an odd experiment that combines demand stabilisation with permanently changing the size of the state. So much simpler to do the obvious thing, and raise government spending to fill the demand gap. As fiscal stimulus in a liquidity trap does not require fine tuning, implementation lags are unlikely to be critical.  

So if we restrict ourselves to fiscal changes that just involve changing the timing of government spending, fiscal demand management in NK models works in much the same way as in TK models, which is simple and intuitive. It really is just a matter of filling the gap.


  1. Simon, on a related note, you might be interested in this interview (David Andolfatto intervierws Michael Woodford). Here's the final bit:


    If you were Chairman of the Federal Reserve, what sort of policy or policy intervention would you be favoring at this time, just endowed with the situation as it has developed to this point?


    It's obviously a very complex situation. In general, I wish the Fed were speaking more about the need for fiscal policy to take on more of the burden of trying to get the economy moving. I'm afraid that, to some extent, the Fed's desire to stress the fact that we still have tools, we haven't used all of our ammunition, has had unfortunate effects. Of course, the intention of that is to reassure the public. The feeling is that letting people be scared that maybe we're out of ideas would itself create uncertainty about the future that would be undesirable for the economy. And that's understandable. But I worry that it's had the undesirable effect of letting Congress off the hook a little too easily by letting them say, "The Fed still has lots of things they can do to take care of the situation, so we can play other games." And I think maybe the Fed would have helped the public debate if it had pushed back a little more on the view that everybody should be assuming the Fed will save everything.


    Sumner discusses other parts of the interview here.

    1. Absolutely. I should add, though, that in this respect at least the Fed were not actively encouraging fiscal austerity. Contrast that with the ECB, and probably also Mervyn King at the Bank of England.

    2. Thanks Simon. I might add that Scott Sumner has since followed up with a couple of comments on the bit of the interview I quote above:

      "We haven’t even scratched the surface of what monetary policy can achieve. For instance NGDPLT is 100 times more potent than fiscal stimulus."

      Do you have any idea how he could have calculated that? Thanks.

    3. "Do you have any idea how he could have calculated that?"

      He decided which one he preferred for ideological reasons, then he constructed an unrealistic model designed to confirm his bias, then he pulled a number out of thin air.

      The usual.

  2. "Ricardian Equivalence. A tax cut today to be financed by tax increases in the future".

    Why any Keynesian should accept it?

  3. Thanks for the response Simon. As always, very intuitive and clear. Good point on the wedge-shaped output gap.

    But suppose the problem is precisely the ZLB. The natural rate of interest is currently too low, and we want to raise it. The TK model says we need to have a higher current level of G, and the expected growth rate of G does not matter. The NK model says we need to have a lower growth rate of G, and the current level of G does not matter. If the ZLB is a binding constraint on the central bank (and the inflation target cannot be raised, for some reason), that means the expected growth rate of G is too high. Some sort of announced phased-in "austerity" program (like the UK has observed?) seems, according to the model, to be just what is needed to lift the economy off the ZLB.

    I worry about the indeterminacy problem. This result is based on just assuming the economy eventually converges (or people expect it to converge) to potential output.

    Must go back to reading Lloyd Metzler and responding to Brad DeLong!

    1. In the NK model you still have to have C+G=Y. So the obvious policy is to raise G, and then let it fall back. Changing the steady state C/G mix is problematic for the reason I gave. Which is why, when people like Werning use these models, they keep the same steady state C/G mix, implying an initial increase in G.

    2. Simon: "In the NK model you still have to have C+G=Y. So the obvious policy is to raise G, and then let it fall back."

      Hmmm. That sound suspiciously like reasoning from an identity!

      One reason for keeping the same steady state G/Y mix is simply that it makes the modelling easier. Plus, you can assume the optimal steady state G/Y mix is a constant, and you are at that optimum.

      Suppose that G had to be chosen and announced one period in advance (not an unrealistic assumption). Suppose the natural rate follows an AR process. The central bank tells you there's been a big negative shock to the natural rate, and the ZLB will be a binding constraint, unless you do something. If you announce G(t+1) will be bigger than G(t), and then slowly decline, you cause an even bigger drop in Y(t). If losses are quadratic in Y-Y*, I don't think that's optimal. (Though it probably depends on the losses in G-G* too).

      My math isn't up to the job, but any delay in implementing the announced jump in G seems to cause a big downward spike in Y?

    3. Agree about the steady state C/G mix, but your idea of reducing G only works by changing that mix - which is what C+G=Y tells you.

    4. Am I missing something?

      Simon talks about a steady state C/G mix, but Nick talks about a steady state G/Y mix.

  4. Re Ricardian equivalence, is there a shred of empirical evidence to support the idea? I find the idea that households calculate what tax increases / debt reduction efforts government might make a few years hence wholly unrealistic. That is, I agree with Joseph Stiglitz who said “Ricardian equivalence is taught in every graduate school in the country. It is also sheer nonsense.” But the nonsense is actually even worse than Stiglitz suggests and for the following reasons.

    A competent government will keep demand, employment and incomes at the maximum level that is consistent with acceptable inflation. That will involve a deficit in some years. But why would government bring about an UNNECESSARY reduction in demand and incomes a few years later simply to repay debt? That would constitute incompetence on the above criterion. I.e. if private sector confidence rose too far, then government would raise taxes and repay debt, but not otherwise. Thus it makes no sense (as Ricardians claim) for households to abstain from consumption now in order to facilitate repayment of debt a few years hence.

    You really have to wonder who understands economics the better: the average household or economists who spend their time fiddling with Ricardian based models.

  5. Simon, TK and NK are so yesterday. The last six years have proven that we are Post Keynesian now. MMT has proven to be correct and even the ONS is talking Stocks and Flows now. Neo-Liberal mainstream economics has proven to be the myth it was always suspected of being, a clever way for rich City Spivs to get richer at the expense of the other 99%. Acorn

    I have built a dynamic stochastic general equilibrium model with an advanced Drag Reduction System; Regenerative Braking plus Launch Control. The latest run says mainstream economics is actually Astrology with numbers.

    1. 'The latest run says mainstream economics is actually Astrology with numbers.'

      I think that's a little unfair. At least there are such things as stars - unlike general equilibria!

  6. Prof Wren-Lewis:
    How does this fit in with the simple model Kevin Murphy (at U of Chicago) used to describe the stimulus. For a non-economist, that model was the clearest explanation of trade offs associated with evaluating stimulus. It seems like the discussion above goes to the estimate of lambda (proportion of output coming from idle resources). But there are several other factors associated with fiscal stimulus that are not covered by this discussion. I was wondering if you can share your thoughts. Professor Murphy's presentation is here (his talk starts at min 17:24 mark)

    Delong's take is here:

    P.S. Apologies if this was a duplicate post...wasnt sure if the previous one went through

    1. Sorry...I said is actually "f' in the presentation

  7. If I've read my Keynes correctly, I'd imagine any TK model would have to take class into account, as in people who make less money tend to spend more of it on a percentage basis. A tax increase on the wealthy today to give money to people who will spend it today will more than make up for any tax deficits in the future by growing the overall economy. The Neo-Keynesians are just Traditional Keynesians who got tired of getting the crap beaten out of them and came up with a lame compromise use the vocabulary of the guys who beat them up. The "fiscal policy is second best" is solid evidence of this. None of this makes much economic sense, which is why it so easy to beat the market.

  8. Great piece Mr. Wren Lewis. However, I was a bit disappointed you didn't explain number 3 a little-why NK thinks fiscal policy is second best. Until you and other distinguished NKers like Krugman and Delong clarify this, I think the confusion over fiscal stimulus will remain.

    Simon Wren-Lewis on the difference between New Keynesianism and Traditional Keynesianism

    I think a good amount of it is caused by Scott Sumner's Market Monetarism. I don't agree with Sumner to say the least but I never see any responses from NKers which meets his argument here head on. Of course, this lack leaves him free to declare victory which he does often.


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