Fiscal multipliers at the zero bound in an open economy

Let’s continue our look at debates over UK fiscal adjustment.

Will fiscal policy work in an open economy? The standard view has
been that in a Mundell-Fleming model fiscal expansion appreciates
the exchange rate and hurts the trade balance, thus offsetting
the fiscal policy. The U.S. may be too closed an economy for this
to be a big deal, but for the UK it seems this might apply, at
least if one is operating within Keynesian frameworks.

The recent Keynesian response has cited the “lower bound” as a
reason why fiscal policy still may be effective in an open
economy. But what does this literature really show? Let’s take a
brief tour of it, starting with the August 2012 piece by Emmanuel Farhi and Ivan Werning,
brilliant Harvard and MIT guys. Their piece is clear and
excellent, and it shows what the case for fiscal policy in this
setting looks like. (I don’t read them as offering concrete
advice to current governments and thus I have no criticism of
their paper, which I am pleased to have spent time with.)

Here are a few points:

1. “…the effects of government consumption work through
inflation.” In other words, if you think the BOE has greater
influence over inflation than UK government spending, you do not
need the other results of this paper for macro policy. I get the
point of “the central bank cannot precommit to elaborate
targeting schemes over time,” but that’s not what we need here.
We just need some basic money-induced price inflation to render
monetary policy dominant over fiscal policy, even in this case.
And pretty much everyone thinks the BOE can influence the rate of
price inflation. The rates of price inflation we are getting are
not some kind of strange coincidence.

By the way, even with a so-called liquidity trap, the BOE also
can play QE with the exchange rate, as do the Swiss.

2. The zero bound open economy model predicts that fiscal
tightening leads to exchange rate appreciation (contra the usual
Mundell-Fleming case), yet here is the British pound against the

Not an obvious fit to the prediction. There are countervailing
factors, to be sure, but maybe that’s the broader story too.

3. The model in the paper suggests that “current” fiscal policy
won’t much help aggregate demand. Fiscal policy does best the
further away in time it is
, provided it does not happen
after the liquidity trap goes away. This makes sense if you view
inflation as the channel for the effectiveness of fiscal policy.
Getting the inflation over with won’t help much, but if it hangs
over people’s heads they will spend more in response. In fact
there is even a problem that the multiplier can be infinite if
fiscal policy is sufficiently well-time and back-loaded.

None of this corresponds with the advice we actually are hearing.

4. The greater the nominal stickiness of prices in the model, the
weaker the Keynesian effects and in the limiting case they
approach zero. Yet we are told (by the policy commentators) that
nominal stickiness is of the utmost importance.

Let’s consider a few other pieces and points:

5. It is common for these papers to rely on squirrely mechanisms
of intertemporal substitution, which in other contexts are mocked
by Keynesians. Consider
Fujiwara and Ueda
, a commonly cited paper on fiscal
multipliers and the zero bound:

Incomplete stabilization of marginal costs due to the existence
of the zero lower bound is a crucial factor in understanding
the effects of fiscal policy in open economies. Thanks to
this, government spending in the home country raises the
marginal costs of home-produced goods, which increases expected
inflation rates and decreases real interest rates.
Intertemporal optimization causes consumption to increase, so
that the fiscal multiplier exceeds one. While government
spending continues, the price of home-produced goods increases
more than that of foreign-produced goods. Expecting that two
countries are at symmetric equilibrium when government spending
ends, the home currency depreciates and the home terms of trade
worsen on impact when government spending begins. That shifts
demand for goods from foreign-produced goods to home-produced
ones. The fiscal spillover thus may become negative depending
on the intertemporal elasticity of substitution in consumption.

If a passage like that came from an RBC theorist it would be
mocked, but in support of activist fiscal policy it passes
without critical comment.

6. When it comes to Japan and the Japanese lower bound, the
empirical evidence seems to show that “standard theory” predicts
quite well and the stranger zero bound theories do not predict
well. Here is Braun and

We show that a prototypical New Keynesian model fit to Japanese
data exhibits orthodox dynamics during Japan’s episode with
zero interest rates. We then demonstrate that this
specification is more consistent with outcomes in Japan than
alternative specifications that have unorthodox properties….

Those same zero bound Keynesian models predict that economies
should have quite volatile responses to real shocks, yet they do

We also considered specifications of the model that have larger
government purchase multipliers and some which also exhibit
unorthodox predictions for the response of output to labor tax
and technology shocks. We found that these specifications are
difficult to square with the fact that the period of zero
interest rates in Japan between 1999 and 2006 was a period of
low economic volatility. All of the specifications predict the
opposite should have occurred. The specifications with
unorthodox properties also have other problems. They predict
large resource costs of price adjustment which are difficult to
reconcile with empirical evidence that menu costs are small and
they require that households expect the period of zero interest
rates to be counterfactually long.

Need I state the irony that proponents of the relevance of the
zero bound often insist that real shocks simply aren’t making
such a big difference in recent years? That is inconsistent with
the basic model which they otherwise are citing.

7. In these settings (and assuming away all the problems above),
a lot of the effectiveness of fiscal policy, or sometimes all of
it, comes from “beggar thy neighbor” effects. Read Cook
and Devereux
for some illustrative cases. Beggar thy neighbor
strategies are criticized and rejected when Germany (supposedly)
does them through its export prowess, but in the context of
fiscal policy they seem to be given a free pass.

8. In fact I could make further points but I believe that is

The bottom line: A look at this new and
interesting literature shows it does not support the
interpretations which the “policy commentariat” Keynesians are
putting on it and in some regards it even opposes those
interpretations. When it comes to UK fiscal policy, we are seeing
again what I described
last week
: exaggeration and a lack of transparency in


This one is interesting too:

The RSS feed is broken

The theoretical arguments for why fiscal policy should be ineffective are welcome, as are the theoretical arguments for why cyclical deficits are not always a good measure for the stance of fiscal policy.

What is missing is a reasonable pragmatic argument. If cyclical deficits are not a good measure of the stance of fiscal policy, and if fiscal policy does not have much of an impact on growth at the zero lower bound, then why is there still a fairly strong correlation in recent years between cyclically-adjusted deficits and growth?

Often those two metrics are simply remeasuring the same underlying change (growth gap, whatever it is caused by), thus the correlation...

I find Nick Rowe's argument about cyclical deficits reasonable -- noise may be introduced because often fiscal policy is ad-hoc, not part of a system of automatic stabilizers.

But the argument that the cyclical adjustment is causing a systematic correlation with growth I find less convincing. It requires assuming that the financial crisis has caused significant structural problems in a diverse set of countries with very different labor markets and regulatory regimes, and that these structural problems are causing the cyclical adjustment to overestimate the output gap ... basically everywhere. That's not impossible, but it seems unlikely. I can see equally valid arguments that our estimates of potential output are too low right now, and the cyclical adjustments are understating the output gap.

FYI some recent posts have been screwy in google reader

The length of an MR post is inversely proportional to its clarity / information-content.........

Does the same apply to comments?

Suppose fiscal policy was not concentrated on increasing consumption (i.e. giving people checks via a program like unemployment or 'social security bonuses' or lowering tax rates) but instead on purchasing actual goods and services that are produced inside the economy? For example, consider an expansion in Medicaid payments int he stimulus package. Since Medicaid ultimately gets paid to hospitals and doctors inside the economy and it's not easy for an economy to quickly 'import doctors' and Medicaid doesn't pay hospitals outside the US. Likewise infrastructure spending mostly has to happen inside an economy. You may be able to import cranes from China but they haven't yet produced ready-made roads and bridges to be shipped in and dropped!

Yes I can see how some can 'leak out'. Doctors and hospital execs may go to a Greek resort for vacation. Nurses and health aids may buy more China imported goods from Wal-Mart, with the additional income they receive but it seems implausible that the effect wouldn't work. The fact is the domestic economy is dramatically under-employed and the most efficient place for stimulus is to first find unemployed resources nearby to tap and then tap overseas resources.

On the flip side, an economy that is super highly dependent on international trade should, IMO, be immune to a Keynesian style recession. Take an economy like the Bahamas where almost all the demand is coming from overseas tourists. How would a Keynesian style recession take hold in such an economy to begin with? If it can't then it's moot to discuss a Keynesian style stimulus to such an economy.

I think in an open economy it is important to consider what is happening with the relevant trading partners. If you have a bunch of open economies that mostly trade with each other, and they are all brought into recession by the same shock, then collectively they can behave like a large, more closed economy in a Keynesian recession.

Bingo! If a Keynesian Recession is essentially a collapse in demand, then the question to ask is what is the source of this demand? If you have a network of highly open economies, the demand shock can very well be coming from abroad. In that case the local economy may simply lack the heft to self-stimulate on its own. Hence you have a reason for Greece to do austerity while at the same time Germany should do stimulus. Because you have an open economy, Germany's stimulus will offset the short term harm of Greece's austerity without causing German inflation. Likewise since most of Greece's demand may come from the rest of Europe, it's not clear that it can even 'self-stimulate' itself. So perhaps the best policy is for Greece to work on austerity to correct its long term budget problems while the rest of the EU helps by stimulating.

That is, in essence, what the US does (or should do). States work on their budgets but the Fed. gov't offsets gains and losses. States doing great pay more income taxes, states doing poorly pay less and get citizens who collect unemployment benefits, food stamps etc.

I think the response to Tyler's question, though, is moot. If an economy is so 'open' that it's fiscal stimulus would simply leak out abroad then the demand (or lack of demand) is also coming from abroad, the 'economic unit' is the source of the Keynesian recession and likely the source of the needed stimulus.

"You may be able to import cranes from China but they haven’t yet produced ready-made roads and bridges to be shipped in and dropped!"

Pretty close:
Bridge Comes to San Francisco With a Made-in-China Label

"You may be able to import cranes from China but they haven’t yet produced ready-made roads and bridges to be shipped in and dropped!"

Pretty close: Bridge Comes to San Francisco With a Made-in-China Label

Hey Tyler, there's something wrong with your introtext. In an RSS feed reader like Google Reader only a random snippet of text appears. This is a very recent (in the last few days) development.

More and more, each day, I have come to realize that economics resembles a debate between religious faiths, with all the same rigorous application of logic.

I on the other hand immediately realized that Yancey Ward is simply not very smart.

Because he's only recently come to that realization?

I'm also having problems with the MR RSS feed in Google Reader.

Richard Koo's telling chart on the balance sheet recession, which clearly shows why the zero bound is not working. People are paying down debt, not taking out new debt at low interest rates.



All the charts

The proof of the economic pudding is in the eating. Today, Jesse Frederik published a post, in Dutch, on the prediction of the Euiropean Comission about Greek economic growth. The first prediction, made about 9 months before the start of the year, was of with about 6 to 8%-points of GDP during the last year (chess players would probably label this as '!!??'), as far as we can gauge mainly because the models used had a very small multiplier:

I'll take care of a graph in english tomorrow. In the meanwhile, I'll send you to the ECB: who also estimated multipliers larger than one (duh...).

But cut the crap: if the Euro has to survive we have to write down 1 trillion of debt, or so, and introduce a European wide tax funded pension scheme.

I enjoyed this post on my commute this morning (sorry Rahul, these are the ones that keep me reading), but then my day turned into a series of reminders that my mind is not wired to enjoy spending serious time with state-of-the-art macro models. Oh well, at least I can (usually) handle blog doses.

I would second under 5) to be wary of models which depend on " squirrely mechanisms of intertemporal substitution" and even add my concern at models that depend on a strong responsiveness of consumption growth to interest rate changes. Yes, there are effects of interest rates, particularly through durables and maybe interests are a signal to households of future income growth. But I wouldn't want to push too hard that households are shifting spending around over time due to the interest rate. Maybe I've seen too much survey evidence that most households have no concept of compound interest and use a pretty short planning horizon (or maybe my brain simply can't appreciate the beauty of macro models with high EIS or other odd household assumptions). The guts of our models deserve as much attention as their results.

On 4, obviously the direction of stickiness is important. Prices are rarely very sticky going up.

About the disasterous consequences of the economic models of the European Commission, which mistakenly and against all available evidence assume that multipliers are low, in a severe depression and which lead to utterly wrong and misleading, albeit politically convenient, predictions. Right-wing economics is indeed a docile servant of the financial interests, private or public. And the predictions of these models are so wrong that it compromises economics as a science:

Please, lets skip DSGE models, with their ill defined variables and ad-hoc structures, and return to scientific economics.


IMF "staff position note" (page 3)
“Can the fiscal multiplier be negative?
Yes, fiscal expansions can be contractionary if they decrease consumers’ and investors’ confidence, especially if the fiscal expansion raises, or reinforces, fiscal sustainability concerns.5“

The way I read the Farhi / Werning piece, they carefully avoid to become quantitative,
and discover a large multiplier for endless gigantic outside transfers, like poor german taxpayers paying for rich greek tax cheats.

I fully agree that this is a perfect and powerful way to boost ones GDP, stealing from others.

"The greater the nominal stickiness of prices in the model, the weaker the Keynesian effects and in the limiting case they approach zero. Yet we are told (by the policy commentators) that nominal stickiness is of the utmost importance."

I'm surprised by that. Could someone explain why nominal stickiness weakens Keynesian effects? I thought (at least in the New Keynesian variant) it depended on them.

Replace Tyler's suggestion that "fiscal policy relies on inflation channel" with "fiscal policy effectiveness relies on central bank tolerance of inflation" and you're immediately much closer to the truth...

The general idea of the zero-bound model is very easy to understand, comes automatically if you were forced to take lectures on the simple Keynesian Cross analysis of the trade balance at University. The basic idea is that with a loanable-funds glut the capital account doesn't really matter anymore, and the trade balance drives the exchange rate. Krugman would tell you that the more complicated models basically come to the same conclusions.

Enjoyable post, thank you! I have one question. As you mentioned in this post, the NK literature argues that expected future changes in government spending have multiplier effects. But in one of your earlier posts you say it is not right to blame austerity for low UK growth because it hasn't happened yet. But based on NK theory couldn't you argue that expected future austerity is putting a drag on UK growth?

p.s. I'm not criticising, just trying to work this out myself and wondered what your thoughts were. Thanks!

Yes. Even more than that, NKs understand that monetary policy drives the price level in the long run, and a price-targeting central bank completely offsets the fiscal balance. So strictly speaking, NKs themselves ought to be agreeing that all austerity is monetary austerity - expected future austerity, expected future low AD, is the same as ongoing tight money...

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