Policies That Might Work I: Fiscal Policy J. Bradford

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Policies that Might Work I: FiscalPolicy

J. Bradford DeLong

University of California at Berkeley and NBERbrad.delong@gmail.comhttp://delong.typepad.com/ +1 925 708 0467

May 12, 2009

How Not to Analyze Fiscal Policy

Eugene Fama:There is an identity in macroeconomics... private investment [PI]must equal the sum of private savings [PS], corporate savings(retained earnings) [CS], and government savings [GS]....(1) PI = PS + CS + GS....The problem is simple: bailouts and stimulus plans are funded byissuing more government debt.... The added debt absorbs savingsthat would otherwise go to private investment.... [S]timulus plansdo not add to current resources in use. They just move resourcesfrom one use to another.... I come back to these fundamental pointsseveral times below....The Sad Logic of a Fiscal Stimulus: In a "fiscal stimulus," thegovernment borrows and spends the money on investment projectsor gives it away as transfer payments to people or states. The hopeis that government spending will put people to work....Unfortunately, there is a fly in the ointment.... [G]overnment

2infrastructure investments must be financed—more governmentdebt. The new government debt absorbs private and corporatesavings, which means private investment goes down by the sameamount....Suppose the stimulus plan takes the form of lower taxes... we can'tget something for nothing this way either... lower tax receipts mustbe financed dollar for dollar by more government borrowing. Thegovernment gives with one hand but takes them back with theother, with no net effect on current incomes...But the flow-of-funds savings-investment identity is true

bydefinition

—whether or not fiscal policy works. You cannot deduce theeffectiveness or ineffectiveness of a policy from an accounting identitythat is true by definition.

How to Analyze Fiscal Policy

Tyler Cowen: with the failure of large-scale Keynesian macroeconometricmodels, with the failure of rational-expectations cross-equation restrictionmacroeconomics, and with the failure of real business cycle theories,macroeconomics has been driven back to a combination of accountingidentities and common sense…Reasons why deficit spending might not work:1.

The price level might rise—so that increases in niminal demandwill not increase real demand.2.

Interest rates might rise and so investment might fall.3.

Savings might rise and so consumption might fall.4.

Foreigners might buy the bonds and so exports might fall.We neglect the first of these: “we wish…”: is the answer.Two roads: flow-of-funds and income-expenditure—should produce thesame answer!

3Start with flow-of-funds. Write down the identity:(2)

S

−

NX

=

(

G

−

T

)

+

I

Consider first a tax increase, and take partials:(3)

S

y

Δ

Y

+

S

i

Δ

i

+

S

t

Δ

T

−

NX

y

Δ

Y

−

NX

i

Δ

i

−

NX

t

Δ

T

=

−Δ

T

+

I

y

Δ

Y

+

I

i

Δ

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+

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t

Δ

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So far we are still in accounting-identity land: we have just created a set of boxes into which to throw arguments about potential effects.Now we pin the interest rate to zero—we are, after all, following as highlystimulative a normal monetary policy as we can here. And let’s neglect theinvestment accelerator as well. So we are left with:(4)

S

y

−

NX

y

( )

Δ

Y

=

NX

t

+

I

t

−

S

t

−

1

( )

Δ

T

(5)

Δ

Y

=

NX

t

+

I

t

−

S

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1

( )

( )

S

y

−

NX

y

( )

Δ

T

The denominator here is the standard Econ 1 Keynesian multiplier, withpermanent-income and open-economy considerations tending to make it2/3 or more, and thus the tax multiplier 1.5 or less.The inner parenthesis in the numerator is a combination of the normalKeynesian tax effect, permanent-income effects, and Ricardian equvalenceeffects. If a $1 temporary tax cut leaves consumptionunaffected—increases current savings by $1—then that term in thenumerator is zero. Otherwise not.Does a temporary tax cut affect net exports through the exchange rate?Well, it leads to expectations of future tax increases, which mightdiscourage imports of capital, which would raise goods exports—so if anything the NX

t

term seems to go in the direction of a bigger taxmultiplier (a long as we are not worrying about price level- or interest

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