The Conceptual Issue with the Fiscal Multiplier: An NK and MM Perspective
We care about consumption. A short piece.
In my previous post, I talked about why the Market Monetarist view of the fiscal multiplier is wrong given empirics and analysis. However, they are only wrong from a certain perspective, the New Keynesian one, and given my sympathies to Monetarism and their views on the fiscal multiplier the last post might present itself as confusing. There are conceptual and semantic breakdowns between Market Monetarists and NKs with regards to the fiscal multiplier; in fact, they’re often talking about two different things.
Recalling what I previously wrote about, Ramey (2011) dictates that a deficit-financed, temporary fiscal injection, has a multiplier of around .8-1.5 - a multiplier of <1 could be chalked up to a traditional crowding out story. Michael Woodford (2011) also shows an >1 fiscal multiplier through fiscal shocks actuating responses in the private sector that influences a list of variables: output, consumption and labour hours. Ramey & Zubairy (2014) used VARs to estimate fiscal multipliers with a military news shock identification technique to show that multipliers can be as high as 1.5 at the ZLB.
Scott Sumner claims that a concept known as monetary offset should cause the fiscal multiplier to be zero:
Why has the effect of fiscal stimulus been so meager in recent years? After all, interest rates in the United States have been close to zero since the end of 2008. The most likely explanation is monetary offset, a concept built into modern central bank policy but poorly understood. We can visualize monetary offset with the Keynesian aggregate supply and demand diagram used in introductory economics textbooks. If fiscal stimulus works, it’s by shifting the aggregate demand (AD) curve to the right. This tends to raise both prices and output as the economy moves from point A to point B, although in the very long run, only prices are affected.
This claim makes sense. In fact, I would agree with it, in theory. The question is, why doesn’t it square up with the data?
I wrote,
In Sumner’s defense, he doesn’t claim that fiscal policy, fiscal shocks, will not affect real output. From his NGDP lens, the multiplier is about fiscal policy’s effect on nominal GDP and/or inflation. But if such is the case, then there isn’t any point to the discussion. Is the phrase “fiscal multiplier” synonymous with the phrase “the effect of an exogenous change in real government purchases on NGDP” or is it synonymous with the phrase “the effect of an exogenous change in real government purchases on RGDP”
So what’s the deal? The issue with this debate is that NK and MMs are often talking about two different things even though they are using the same label, the fiscal multiplier.
Let’s treat Y = C + G as a resource constraint. Y represents total output, C represents consumption and G represents government spending.
NKs will reference the fiscal multiplier as the effect of government spending, G, on output Y - we can represent this as dY/dG.
Market Monetarists implicitly reference the effect of government spending, G, on consumption, C - we can represent this as dC/dG. The MM perspective on the fiscal multiplier, in my opinion, is more relevant for policy discussion since consumption is what matters for welfare - monetary authorities should be primarily concerned with stabilizing nominal spending. For example, if government spending increases total output, Y, through digging holes and dumping dirt into the ocean - and doing so does not raise the consumption of households - then who cares?
If we were to take the derivative of our resources constraint, Y = C + G, we would have dC/dG = dY/dG - 1. When MMs talk about “the fiscal multiplier being roughly zero”, their claim is that dC/dG is equal to zero, not referencing dY. This is why NK estimates are generally centered around 1 while MMs say “roughly zero".
Hence,
Is the phrase “fiscal multiplier” synonymous with the phrase “the effect of an exogenous change in real government purchases on NGDP” or is it synonymous with the phrase “the effect of an exogenous change in real government purchases on RGDP”