Tuesday, June 14, 2011

A reason for further fiscal stimulus

The economists Christiano, Eichenbaum, and Rebelo have developed an interesting paper in the February JPE (Journal of Political Economy) called, "When is the government spending multiplier large?" They argue that the government spending multiplier will change with the market environment.

The spending multiplier is critical for the success of any stimulus program. A low spending multiplier means that there will not be any follow-through from the increase in government spending. Hence, the value of a new spending program should be questioned as unproductive. A high spending multiplier will mean that a dollar of fiscal spending will translate into more than a dollar of GDP. The spending multiplier will be lower if there is an interest rate effect whereby increase spending will lead to higher rates based on the crowding out effects. If rates rise, then private spending may decrease, lower the impact of any government spending. If there was no interest rate effect, then the multiplier will be higher.

The spending multiplier is not stable because the interest rate environment is variable. If the economy is in a zero interest rate environment then there will be less interest rate effect which will drive the multiplier higher. The deflationary spiral or the paradox of thrift will place the economy at risk and there potential move in interest rates will be limited. Hence, this would be the time to use fiscal stimulus to get the economy moving. If there is expected a longer zero bound environment, the multiplier will be larger.

While it is difficult to advocate, there is a reason for controlled policies to help the economy move. The limited rate effect means there will be greater bang for every dollar spent.


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