When Is the Government Spending Multiplier Large?

This paper argues that the government-spending multiplier can be much larger than one when the nominal interest rate is constant – most naturally because the zero lower bound on nominal interest rates binds – and that the larger the fraction of new spending that arrives while the rate is stuck at zero, the larger the multiplier. The authors build the argument in three steps. First, in a simple new-Keynesian model without capital in which the central bank follows a Taylor rule, the government-spending multiplier is modest, generally close to or a little above one for plausible parameters, because a fiscal expansion that raises output and expected inflation triggers an interest-rate response that crowds out private spending. Second, when the nominal rate is instead held constant – the natural case being a large, temporary rise in the representative household’s discount factor (a stand-in for a rise in the desire to save) large enough to push the zero bound into a binding state – an increase in government spending instead counteracts a self-reinforcing deflationary spiral: higher expected inflation lowers the real interest rate, which raises private spending, output, and inflation further, in contrast to the Taylor-rule case where the same channel runs the other way. In their baseline calibration the zero-bound multiplier is 3.7, roughly three times the standard multiplier, and the multiplier is shown analytically to be larger precisely in economies where the output cost of being stuck at the zero bound is itself larger; it is also larger the longer government spending is expected to arrive while the bound still binds, and shrinks sharply if the spending instead arrives only after the bound stops binding. Third, quantifying the mechanism in the medium-scale, estimated DSGE model of Altig, Christiano, Eichenbaum, and Lindé (2011), which adds sticky wages, habit formation, variable capital utilization, and investment adjustment costs to the simple model, the authors find an impact multiplier of roughly 1.6 and a peak multiplier of about 2.3 when spending is elevated for twelve quarters while the zero bound binds, compared with less than one under an active Taylor rule; the same model, hit with a discount-factor shock and a financial-intermediation-cost shock calibrated to 2008-2010 credit spreads, reproduces the broad shape of the 2008-2010 collapse in output, consumption, investment, and inflation and the fall of the federal funds rate to zero. The paper further shows that financing the spending increase with distortionary labor-income or household-borne capital-income taxes raises, rather than lowers, the multiplier while the zero bound binds, the opposite of the standard result away from the bound, and that the same logic implies it can be socially optimal to raise government spending very substantially – in the authors’ calibration to roughly 30 percent of GDP from a steady-state 20 percent – when the zero bound binds. The authors are explicit that their analysis abstracts from political-economy considerations bearing on the difficulty of reversing new spending programs, and that reduced-form estimation of the zero-bound multiplier from historical data is largely infeasible because multipliers differ so much across regimes and government spending itself typically rises endogenously in response to the same shocks that make the bound bind.

Lawrence Christiano | Macro Paper Warehouse

When Is the Government Spending Multiplier Large?