Multipliers and Assumptions

By Fester:

Menzie Chinn at Econbrowser is linking to an interesting paper on the multiplier argument.  This paper looks at the response of the Federal Reserve and other central banks as a key component of determining the multiplier effect. 

The paper also simulates the general equilibrium impacts of the government spending path implied by the 2009 American Recovery and Reinvestment Act. When the government spending path is modeled as a sequence of shocks to spending, the present-value multiplier for output is about $0.68 under a fixed regime of AM/PF, while it can be well over $3.00 in a fixed [Passive Money/Active Fiscal] PM/AF regime. If the government spending path is treated as foreseen by economic agents -- because the path is announced by the passage of the Act -- the present-value multiplier for output falls somewhat when the regime is AM/PF, but it rises to nearly $5.00 in the short run when policy obeys a PM/AF regime.

Basically the AM/PF policy assumes that the Federal Reserve will act in opposition to fiscal policy.  Its counter-action will be seen in the rise in short term interest rates to counter-act the expected long term inflation of the fiscal stimulus.  Higher interest rates lead to higher borrowing costs and thus lower economic activity.  The deadweight costs of future tax increases leads to the negative NPV of the stimulus under this operating assumption.  These assumptions le one to the policy is ineffective no matter what camp as the Fed will cancel out Congress in this scenario. 

The PM/AF policy regime assumes the the Fed won't be monkeying around with higher interest rate changes.  Instead, it will hold rates steady and low.  The Fed accepts the risk of higher future inflation while fiscal policy (money spent by Congress) is allowed to flow through the system.

Right now, I think it is clear that we are in a PM/AF regime.  The Federal Reserve is operating under the assumption that we are ina liquidity trap and thus are keeping the short term rates as close to zero as possible. Inflation is not projected to get out of control so the inflation fighting mandate will not be invoked.  Right now, thhere is still some risk of deflation.  I think it is reasonable to assume that in the short run, the Federal Reserve will continue to be accomodative.  Congresswill not be significantly more active as there is already talk about moving towards a structurally balanced budget in the intemediate term, and there is little political will or support for a second stimulus package despite the fact that the first one was too damn small at its proposal and made even smaller by the Even Number Cut caucus.  So we may be closer to a PM/PF policy in the near future rather than the current PM/AF policy as the ARRA fund flows will start increasing in volume and velocity this quarter.