Cracking Christiano, Eichenbaum, and Rebelo's Big Multipliers without Coffee...
Greg Mankiw asks a question:
Greg Mankiw's Blog: Modern macro even Paul Krugman will love: Lately, Paul Krugman has been dissing modern macroeconomics, mainly because many macroeconomists do not agree with his conclusions about fiscal policy. This new paper by Marty Eichenbaum, Larry Christiano, and Sergio Rebelo should, however, make Paul happy. They report large fiscal policy multipliers in a new Keynesian DSGE model when the economy is at the zero interest lower bound.
An open question: How can the results in this paper be reconciled with results by John Cogan, Tobias Cwik, John Taylor, and Volker Wieland, who seem to perform a similar policy simulation in a similar model but reach a very different conclusion? Are there subtle differences in the models? Or subtle differences in the policy experiments? Or did one team simply make a mistake of some sort?
Figuring out why these two prominent teams of researchers come to opposite conclusions about fiscal policy multipliers, and which conclusion is more applicable to actual policy, would be a good paper topic for an ambitious grad student.
As I understand it, the big problem with Cogan, Cwik, Taylor, and Wieland is that there is nothing special going on at the zero nominal interest rate bound. In their model, a fiscal expansion (a) raises expected future inflation, which (b) creates expectations of future interest rate rises by the Federal Reserve to cool off that inflation, which (c) damps present spending, and so (d) shrinks the multiplier. Their model is a model of a small multiplier in an economy away from the zero nominal interest rate bound when central banks are targeting inflation.
Christiano, Eichenbaum, and Rebelo, by contrast, have a model in which:
a shock increases desired savings.... When the shock is small enough, the real interest rate falls and there is a modest decline in output. However, when the shock is large enough, the zero bound becomes binding.... The only force that can induce the fall in saving required to re-establish equilibrium is a large transitory fall in output. The fall in output must be very large because hitting the zero bound creates an economic meltdown. A fall in output lowers marginal cost and generates expected deflation which leads to a rise in the real interest rate. This increase in the real interest rate leads to a rise in desired savings which partially undoes the effect of the fall in output. As a consequence, the total fall in output required to reduce savings to zero is very large. This scenario captures the paradox of thrift originally emphasized by Keynes (1936).... The government spending multiplier is large when the zero bound is binding because an increase in government spending lowers desired national savings and shortcuts the meltdown created by the paradox of thrift...
That said, I think that the CER multipliers are much too large to be applicable to our world today. If I understand CER completely (which I may not: the coffee has not yet hit the brain this morning), their Calvo pricing assumption creates a direct link between output Y and inflation π. Recall the flow -of-funds balance equation:
S(Y, 0-π) = D + I(0-π)
Savings S as an increasing function of income Y and of the real interest rate, which is the nominal interest rate 0 (we are at the lower bound) minus the inflation rate π, is equal to the government deficit D plus investment I which is a decreasing function of the real interest rate, which is the nominal interest rate 0 minus the inflation rate π.
An increase in the deficit thus (a) directly increases saving S necessary to finance the deficit which requires a direct increase in Y. But this direct increase in Y then increases inflation π--there is less deflation. And less deflation means both less savings and more investment. So the direct effect increase in Y does not generate enough savings to close the gap in the flow-of-funds market: savings must increase by more--which requires that Y increase by even more. The government deficit thus genuinely "primes the pump" and the multiplier is very large.
This channel is, I think, the channel pointed to by those who think that the New Deal had an enormous impact, as Roosevelt's deficits in combination with the increase in price rigidity produced by the NIRA and the breaking of deflationary expectations created by the abandonment of the gold standard diminished desired S.
But I don't think we have big expectations of deflation right now. And I don't think fiscal policy moves right now are having a great deal of effect in reducing expected deflation. So I don't think the interaction of output gaps and deflation is playing a big role in boosting the multiplier right now...
I may well, however, assign CER next March when I hit the Great Depression week in Econ 210a as an argument for why Cary Brown's estimates of the fiscal policy effect of the New Deal are too low...
And it is nice to see a model in which J. Bradford DeLong and Lawrence H. Summers (1986), "In Increased Price Flexibility Destabilizing?" American Economic Review makes a reappearence...
