New Keynesian versus old Keynesian government spending multipliers

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Abstract

Renewed interest in fiscal policy has increased the use of quantitative models to evaluate policy. Because of modelling uncertainty, it is essential that policy evaluations be robust to alternative assumptions. We find that models currently being used in practice to evaluate fiscal policy stimulus proposals are not robust. Government spending multipliers in an alternative empirically estimated and widely cited new Keynesian model are much smaller than in these old Keynesian models; the estimated stimulus is extremely small with GDP and employment effects only one-sixth as large and with private sector employment impacts likely to be even smaller. We investigate the sensitivity of our findings with regard to the response of monetary policy, the zero bound on nominal interest rates and the inclusion of an empirically relevant degree of rule-of-thumb behaviour in the new Keynesian model. In addition, we relate our findings using estimated structural macroeconomic models to the recent literature using reduced-form regression techniques.

Introduction

In a recent paper1 Christina Romer, Chair of the President's Council of Economic Advisers, and Jared Bernstein, Chief Economist of the Office of the Vice-President, provided numerical estimates of the impact of an increase in government spending on GDP and employment in the United States. Such estimates are a crucial input for the policy making process. They help determine the appropriate size and timing of countercyclical fiscal policy packages and they help inform members of the Congress and their constituents about whether a vote for a policy is appropriate. For packages approaching $1 trillion including interest, as in 2009, the stakes are enormous. The estimated economic impacts matter.

The Romer–Bernstein estimates are based on two particular quantitative macroeconomic models—one from the staff of the Federal Reserve Board and the other from an unnamed private forecasting firm. By averaging the impacts generated by these two models, they estimate that an increase in government purchases of 1 percent of GDP would induce an increase in real GDP of 1.6 percent compared to what it otherwise would be. Their results are shown in Fig. 1. Also shown in Fig. 1 are the estimated effects of exactly the same policy change—a permanent increase in government purchases—as reported in another study published a number of years ago by one of us.2

It is clear from Fig. 1 that the results are vastly different between the different models. Perhaps the most important difference is that in one case higher government spending keeps on adding to GDP “as far as the eye can see,” while in the other case the effect on GDP diminishes as non-government components are crowded out by government spending.

Macroeconomists remain quite uncertain about the quantitative effects of fiscal policy. This uncertainty derives not only from the usual errors in empirical estimation but also from different views on the proper theoretical framework and econometric methodology. Therefore, robustness is a crucial criterion in policy evaluation. Robustness requires evaluating policies using other empirically estimated and tested macroeconomic models. From this perspective Fig. 1 is a concern because it shows that the Romer–Bernstein estimates apparently fail a simple robustness test, being far different from existing published results of another model. For these reasons an examination of the Romer–Bernstein results is in order.

Section snippets

The need for an alternative assessment

We think it is best to start by conducting a fresh set of simulations with a macroeconomic model other than one of those used in Fig. 1. We focus on the Smets–Wouters model of the US economy.3

The problem with an interest rate peg

Romer and Bernstein assume that the Federal Reserve pegs the interest rate—the federal funds rate—at the current level of zero for as long as their simulations run. Given their assumption that the spending increase is permanent, this means forever. In fact, such a pure interest rate peg is prohibited in new-Keynesian models with forward-looking households and firms because it produces calamitous economic consequences. As Thomas Sargent and Neil Wallace6

Government spending multipliers: new Keynesian versus old Keynesian

Table 1 shows the response of real GDP to a permanent increase in government purchases of 1 percent of GDP in the new-Keynesian model and contrasts these with the average of the two models of Romer and Bernstein. The simulations are done using a new database of macroeconomic models designed explicitly with the purpose of doing such policy evaluation and robustness studies.7

Alternative assumptions about monetary policy

Table 2 shows what would happen if the length of time for which the federal funds rate is anticipated to remain constant is shorter and extends only through the end of 2009. In other words we now assume that the Fed starts following its feedback rule for policy starting in 2010 rather than waiting until 2011.

The impacts in Table 2 are uniformly smaller through 2011 than those in Table 1 because interest rates can begin to increase earlier (in 2010 rather than 2011) accelerating the crowding-out

A more realistic path for government purchases

Although a permanent increase in government purchases of goods and services is a good way to understand the properties of a model, it is not a realistic description of the fiscal policy packages under consideration in the United States and other countries recently nor of the final $787 billion fiscal stimulus package enacted and signed into law8 on February 17, 2009. For example, about half of that fiscal

Estimated impacts

According to the Smets–Wouters model, the impacts of this package on GDP are very small. But particularly worrisome is that during the first year the estimated stimulus is minor and then even turns down in the third quarter. Why the very small effect in the first year?

The answer comes in part from the timing of the government expenditures and the forward-looking perspective of households. The small amount of government spending in the first year is followed by a larger increase in the second

Too Keynesian or not Keynesian enough?

A possible criticism of new-Keynesian models such as Christiano et al. (2005) and Smets and Wouters (2007) is that they are not Keynesian enough, because they assume that all households are forward-looking and optimize their spending decisions. Some have suggested that one should allow for the possibility that some households follow “rules of thumb” like the original Keynesian consumption function with a high and constant marginal propensity to consume. Others have proposed to assume that many

Reduced-form empirical evidence and the importance of anticipation effects

So far, we have investigated the magnitude of government spending multipliers and the effects of the ARRA legislation using estimated structural macroeconomic models of the US economy. However, there also exists a large literature that utilizes reduced-form methods in order to identify the likely effects of government spending shocks on the US economy. As emphasized by Ramey (2009) this literature remains divided on central questions such as whether the GDP effect is greater than unity and

Fiscal stimulus in the 2008/09 recession and the zero bound on nominal interest rates

Many commentators on the monetary and fiscal responses to the 2008/09 recession have argued that the special circumstance of near zero nominal interest rates provides a strong argument in favour of fiscal stimulus. The argument goes as follows: the Federal Reserve might want to lower nominal interest rates further but is prevented from doing so by the zero-interest-rate floor that arises because savers can use cash as a zero-interest bearing asset. As a consequence, the Fed may not want to

Impacts of an entire US stimulus package

Although the simulations in this paper have focussed on government spending multipliers in the case of changes in government purchases of goods and services, it is possible to say something about the impact of the broader US fiscal stimulus package, which also includes tax rebates and one-time transfer payments to individuals. For this purpose we focus on the impact in the fourth quarter of 2010 where the size of the increased government purchases (including 60 percent of transfers to states

Conclusions and outlook

In this paper, we used a modern empirical approach to estimate government spending multipliers, and we contrasted these multipliers with those that have recently been used in practice to analyze fiscal policy in the United States. We focused on an empirically estimated macroeconomic model—the Smets–Wouters model—recently published in the American Economic Review. As attested by leading macroeconomic researchers, such as Michael Woodford in his recent survey, this model well represents

Acknowledgements

Wieland thanks the European Central Bank for support and hospitality as Willem Duisenberg Research Fellow while writing this paper. The views expressed in this paper should not be attributed to the European Central Bank or its staff. Helpful comments by Peter Ireland, Harris Dellas, Gunter Coenen, Alistair Dieppe, Joe Grundfest, Albert Marcet, Frank Smets, Rafael Wouters and seminar and conference participants at Goethe University, the European Central Bank, the Kiel Institute of World

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