Page 135 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes elsewhere. But in a recession, when workers and factories lie idle, a fiscal boost can
increase overall demand. And if the initial stimulus triggers a cascade of expenditure
among consumers and businesses, the multiplier can be well above one.
The multiplier is also likely to vary according to the type of fiscal action. Government
spending on building a bridge may have a bigger multiplier than a tax cut if consumers
save a portion of their tax windfall. A tax cut targeted at poorer people may have a bigger
impact on spending than one for the affluent, since poorer folk tend to spend a higher
share of their income.
Crucially, the overall size of the fiscal multiplier also depends on how people react to
higher government borrowing. If the government’s actions bolster confidence and revive
animal spirits, the multiplier could rise as demand goes up and private investment is
“crowded in”. But if interest rates climb in response to government borrowing then some
private investment that would otherwise have occurred could get “crowded out”. And if
consumers expect higher future taxes in order to finance new government borrowing,
they could spend less today. All that would reduce the fiscal multiplier, potentially to
below zero.
Different assumptions about the impact of higher government borrowing on interest
rates and private spending explain wild variations in the estimates of multipliers from
today’s stimulus spending. Economists in the Obama administration, who assume that the
federal funds rate stays constant for a four-year period, expect a multiplier of 1.6 for
government purchases and 1.0 for tax cuts from America’s fiscal stimulus. An alternative
assessment by John Cogan, Tobias Cwik, John Taylor and Volker Wieland uses models in
which interest rates and taxes rise more quickly in response to higher public borrowing.
Their multipliers are much smaller. They think America’s stimulus will boost GDP by
only one-sixth as much as the Obama team expects.
When forward-looking models disagree so dramatically, careful analysis of previous
fiscal stimuli ought to help settle the debate. Unfortunately, it is extremely tricky to
isolate the impact of changes in fiscal policy. One approach is to use microeconomic case
studies to examine consumer behaviour in response to specific tax rebates and cuts. These
studies, largely based on tax changes in America, find that permanent cuts have a bigger
impact on consumer spending than temporary ones and that consumers who find it hard
to borrow, such as those close to their credit-card limit, tend to spend more of their tax
windfall. But case studies do not measure the overall impact of tax cuts or spending
increases on output.
An alternative approach is to try to tease out the statistical impact of changes in government
spending or tax cuts on GDP. The difficulty here is to isolate the effects of fiscal-stimulus
measures from the rises in social-security spending and falls in tax revenues that naturally
accompany recessions. This empirical approach has narrowed the range of estimates in
some areas. It has also yielded interesting cross-country comparisons. Multipliers are
bigger in closed economies than open ones (because less of the stimulus leaks abroad via
imports). They have traditionally been bigger in rich countries than emerging ones (where
investors tend to take fright more quickly, pushing interest rates up). But overall
economists find as big a range of multipliers from empirical estimates as they do from
theoretical models.
These times are different
To add to the confusion, the post-war experiences from which statistical analyses are
drawn differ in vital respects from the current situation. Most of the evidence on multipliers

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