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Friday, October 25, 2013

Fiscal Multipliers: Liquidity Traps and Currency Unions

First paper at the conference is interesting:

Fiscal Multipliers: Liquidity Traps and Currency Unions, by Emmanuel Farhi and Iván Werning, NBER: We provide explicit solutions for government spending multipliers during a liquidity trap and within a fixed exchange regime using standard closed and open-economy models. We confirm the potential for large multipliers during liquidity traps. For a currency union, we show that self-financed multipliers are small, always below unity. However, outside transfers or windfalls can generate larger responses in out- put, whether or not they are spent by the government. Our solutions are relevant for local and national multipliers, providing insight into the economic mechanisms at work as well as the testable implications of these models.

Discussant: The "Keynesian demand effect can potentially be very large." Here is a bit of the introduction that explains further:

1 Introduction Economists generally agree that macroeconomic stabilization should be handled first and foremost by monetary policy. Yet monetary policy can run into constraints that impair its effectiveness. For example, the economy may find itself in a liquidity trap, where interest rates hit zero, preventing further reductions in the interest rate. Similarly, countries that belong to currency unions, or states within a country, do not have the option of an independent monetary policy. Some economists advocate for fiscal policy to fill this void, increasing government spending to stimulate the economy. Others disagree, and the issue remains deeply controversial, as evidenced by vigorous debates on the magnitude of fiscal multipliers. No doubt, this situation stems partly from the lack of definitive empirical evidence, but, in our view, the absence of clear theoretical benchmarks also plays an important role. Although various recent contributions have substantially furthered our understanding, to date, the implications of standard macroeconomic models have not been fully worked out. This is the goal of our paper.
We solve for the response of the economy to changes in the path for government spending during liquidity traps or within currency unions using standard closed and open-economy monetary models. ...
Our results confirm that fiscal policy can be especially potent during a liquidity trap. The multiplier for output is greater than one. The mechanism for this result is that government spending promotes inflation. With fixed nominal interest rates, this reduces real interest rates which increases current spending. The increase in consumption in turn leads to more inflation, creating a feedback loop. The fiscal multiplier is increasing in the degree of price flexibility, which is intuitive given that the mechanism relies on the response of inflation. We show that backloading spending leads to larger effects; the rationale is that inflation then has more time to affect spending decisions.
In a currency union, by contrast, government spending is less effective at increasing output. We show that consumption is depressed, so that the multiplier is less than one. Moreover, price flexibility diminishes the effectiveness of spending, instead of increasing it. We explain this result using a simple argument that illustrates its robustness. Government spending leads to inflation in domestically produced goods and this loss in competitiveness depresses private spending. Applied to current debates in Europe, this highlights a possible tradeoff: putting off fiscal consolidation may postpone internal devaluations that actually help reactivate private spending.
It may seem surprising that fiscal multipliers are necessarily less than one whenever the exchange rate is fixed, because this contrasts sharply with the effects during liquidity traps. Our analytical approach allows us to uncover the crucial difference in monetary policy: although a fixed exchange rate implies a fixed nominal interest rate, the converse is not true. Indeed, we prove that the liquidity trap analysis implicitly combines a shock to government spending with a one-off devaluation. The positive response of consumption relies entirely on this devaluation. A currency union rules out such devaluations, explaining the negative response of consumption.
In the context of a currency union, our results uncover the importance of transfers from the outside, from other countries or regions. In the short run, when prices haven’t fully adjusted, positive transfers from the rest of the world increase the demand for home goods, stimulating output. We compute “transfer multipliers” that capture the response of the economy to transfers from the outside. We show that these multipliers may be large and depend crucially on the degree of openness of the domestic economy.
Outside transfers are often tied to government spending. In the United States federal military spending allocated to a particular state is financed by the country as a whole. The same is true for exogenous differences in stimulus payments, due to idiosyncratic provisions in the law. Likewise, idiosyncratic portfolio returns accruing to a particular state’s coffers represent a windfall for this state against the rest. When changes in spending are financed by such outside transfers, the associated multipliers are a combination of self-financed multipliers and transfer multipliers. As a result, multipliers may be substantially larger than one.
Finally, we explore non-Ricardian effects from fiscal policy by introducing hand-to- mouth consumers. We think of this as a tractable way of modeling liquidity constraints. In both in a liquidity trap and in a currency union, government spending now has an additional stimulative effect. It increases the income and consumption of hand-to-mouth agents. This effects is largest when spending is deficit financed; indeed, the effects may in some cases depend entirely on deficits, not spending per se. Overall, although hand to mouth consumers introduce an additional effect most of our conclusions, such as the comparison of fiscal multipliers in a liquidity trap and a currency union, are unaffected. ...

    Posted by on Friday, October 25, 2013 at 07:54 AM in Academic Papers, Conferences, Economics | Permalink  Comments (59)



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