Sunday, September 06, 2009

How large is the fiscal policy multiplier?

Volker Wieland's answer:
Once you allow for a significant role of forward-looking behaviour by households and firms, there is no multiplier. The expectation of future tax increases, or rising government debt and future interest rate increases leads to a reduction in private consumption and investment spending. This holds in particular for the three New Keynesian models developed by economists at the ECB, the IMF and the EU Commission (see Smets and Wouters 2003, Laxton and Pesenti 2003, and Ratto, Roeger and in’t Veld 2009). These models include extensive Keynesian features such as price and wage rigidities, but also employ up-to-date microeconomic foundations. The model of EU Commission researchers is especially interesting because it is recently estimated and one-third of its households do not care about the future and follow a traditional Keynesian consumption function.
Update: A reader emails me a recent, related study, which makes an important point: The impact of a fiscal change depends on whether and how quickly people expect it to be reversed. If the fiscal stimulus is very temporary and soon to be reversed, the crowding out effects described above by Wieland will be smaller, and the effects on output will be larger.