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.