Measuring the Output Responses to Fiscal Policy

This 2012 American Economic Journal: Economic Policy paper by Alan Auerbach and Yuriy Gorodnichenko estimates how government spending multipliers vary with the state of the business cycle, using a smooth-transition structural VAR (STVAR) fit to postwar quarterly U.S. data. The authors find that government spending is considerably more effective at raising output in recessions than in expansions: in their baseline estimates the cumulative multiplier runs roughly 0 to 0.5 in expansions but 1 to 1.5 in recessions, consistent with both older Keynesian intuition and newer zero-lower-bound DSGE models. Disaggregating spending, they find multipliers differ sharply by component, with military/defense spending showing the largest and most cyclically sensitive response (peaking near 4 in recession). Purging fiscal shocks of the portion that professional and government forecasters could already predict – using real-time forecasts from the Michigan RSQE model, the Survey of Professional Forecasters, and Federal Reserve Board staff projections – further raises the estimated recession multiplier, since much of what a standard VAR treats as a “shock” is in fact anticipated. The results are specific to the postwar U.S. sample and to the historical persistence of fiscal shocks within it, and the authors caution that lumping together historically distinct types of recessions (financial-crisis recessions vs. monetary-contraction recessions) may obscure further heterogeneity in the multiplier.

The Case for Open-Market Purchases in a Liquidity Trap

Auerbach and Obstfeld argue that even if money and bonds are perfect substitutes at a zero short-term nominal interest rate – the textbook reason open-market operations are said to be powerless in a liquidity trap – large-scale central bank purchases of government debt still carry a powerful fiscal benefit: trading money for interest-bearing debt reduces future debt-service requirements and the distorting taxes needed to finance them, as long as the economy has any positive probability of eventually escaping the trap and long-term rates are currently positive (as they were in Japan). Using a dynamic general-equilibrium model calibrated to Japan’s position in the early 2000s, they show that this same mechanism also makes open-market purchases effective for conventional stabilization: because current prices are pinned down by the money stock expected to prevail once interest rates eventually turn positive, a permanent increase in the money supply today raises prices immediately, even while the short-term rate remains at zero. In their baseline numerical simulations a one-time, permanent money-stock increase of 10 percent raises welfare by about 0.84 percent of output per year, and the gains are large but less than proportionally so for bigger expansions. The authors argue the key credibility problem in Krugman’s (1998) account of the liquidity trap – that a central bank cannot commit not to reverse a one-off increase in the money supply – is implausible once the fiscal benefits of debt reduction are taken into account, because in their model there is no welfare gain, and in fact a loss, from reversing a permanent expansion.

Alan J. Auerbach | Macro Paper Warehouse

Measuring the Output Responses to Fiscal Policy

The Case for Open-Market Purchases in a Liquidity Trap