People often object to the idea of a multiplier because it comes from the old Keynesian model. Real macroeconomists, we are told, use DSGE models. But using a DSGE model doesn't matter, the result is essentially the same:
A case for balanced-budget stimulus, by Pontus Rendahl, Vox EU: ...there is little, if any, support in the current macroeconomic literature for the view that expansionary fiscal policy must come at the price of ramping up debt. In fact,... a ‘balanced-budget stimulus’ can set the economy on a steeper recovery path...
[W]hile Ricardian equivalence might have put a nail in the coffin of the Keynesian multiplier, it has certainly not pre-empted the underlying idea: that an increase in government spending may provoke a kickback in output many times the amount initially spent. Indeed, a body of recent research suggests that the fiscal multiplier may be very large, independently of the foresightedness of consumers (Christiano et al 2011, Eggertson 2010). And in a recent study of mine (Rendahl 2012), I identify three crucial conditions under which the fiscal multiplier can easily exceed 1 irrespective of the mode of financing. These conditions, I argue, are met in the current economic situation.
Condition 1. The economy is in a liquidity trap … When interest rates are near, or at, zero, cash and bonds are considered perfect substitutes. ...
Under these peculiar circumstances the laws of macroeconomics change. A dollar spent by the government is no longer a dollar less spent elsewhere. Instead, it’s a dollar less kept in the mattress. And the logic underpinning Say’s law – the idea that the supply of one commodity must add to the immediate demand for another – is broken. ...
Condition 2. … with high unemployment …
So while a dollar spent by the government is not a dollar less spent elsewhere, it is not immediate, nor obvious, whether this implies that government spending will raise output. The second criterion therefore concerns the degree of slack in the economy.
If unemployment is close to, or at, its natural rate, an increase in spending is unlikely to translate to a substantial rise in output. Labor is costly and firms may find it difficult to recruit the workforce needed to expand production. An increase in public demand may just raise prices and therefore offset any spending plans by the private sector.
But at a high rate of unemployment, the story is likely to be different. The large pool of idle workers facilitates recruitment, and firms may cheaply expand business. An increase in public demand may plausibly give rise to an immediate increase in production, with negligible effects on prices. Crowding-out is, under these circumstances, not an imminent threat.
Combining the ideas emerging from Conditions 1 and 2 implies that the fiscal multiplier – irrespective of the source of financing – may be close to 1 (cf Haavelmo 1945).
Condition 3. … which is persistent
But if unemployment is persistent, these ideas take yet another turn. A tax-financed rise in government spending raises output, and lowers the unemployment rate both in the present and in the future. As a consequence, the increase in public demand steepens the entire path of recovery, and the future appears less disconcerting. With Ricardian or forward-looking consumers, a brighter outlook provokes a rise in contemporaneous private demand, and output takes yet another leap. Thus, with persistent unemployment, a tax-financed increase in government purchases sets off a snowballing motion in which spending begets spending.
Where does this process stop? In a stylised framework in which there are no capacity constraints and unemployment displays (pure) hysteresis, I show that the fiscal multiplier is equal to the inverse of the elasticity of intertemporal substitution, a parameter commonly estimated to be around 0.5 or lower. Under such conditions, the fiscal multiplier is therefore likely to lie around 2 or thereabout.
To provide more solid grounds to these arguments, I construct a simple DSGE model with a frictional labour market.1 A crisis is triggered by an unanticipated (and pessimistic) news shock regarding future labour productivity. As forward-looking agents desire to smooth consumption over time, such a shock encourages agents to save rather than to spend, and the economy falls into a liquidity trap. In similarity to the aforementioned virtuous cycle, a vicious cycle emerges in which thrift reinforces thrift, and unemployment rates are sent soaring. ...
There are three important messages [from the work]:
- First, for positive or small negative values of the news shock, the multiplier is zero. The reason is straightforward: With only moderately pessimistic news, the nominal interest rate aptly adjusts to avert a possible liquidity trap, and a dollar spent by the government is simply a dollar less spent by someone else.
- Second, however, once the news is ominous enough, the economy falls into a liquidity trap. The multiplier takes a discrete jump up, and public spending unambiguously raises output. Yet, in a moderate crisis with an unemployment rate of 7% or less, private consumption is at least partly crowded-out.
- Lastly, however, in a more severe recession with an unemployment rate of around 8% or more, the multiplier rises to, and plateaus at, around 1.5. Government spending now raises both output and private consumption, and unambiguously improves welfare...
As evidence that theoretical models -- the DSGE models used in modern macroeconomics -- support fiscal policy, and that the implied multipliers are relatively high in severe recessions, it becomes increasingly clear that much of the opposition to fiscal policy is ideological.