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Blinder, Solow - JME (1976)
Blinder, Solow - JME (1976)
A reply
Alan S. BLINDER
Princeton University, Princeton, NJ 08540, U.S. A.
Robert M. SOLOW*
MIT, Cambridge, MA 02139, U.S.A.
1. Introduction
Ettore Infante and Jerome Stein have produced a fair and painstaking review
of our two articles, ‘Does fiscal policy matter?’ and ‘Analytical foundations
of fiscal policy’ (henceforth, ‘Analytical’j. We find their section 2 very balanced
and ver!’ accurate, and thank them for avoiding what must have been an irresis-
tible temptation to refer to us by the first letters of our respective last names.
However, in sections 3 anti14, they suggest that fiscal policy rests on rather
weak analytical foundations after a11 At the risk of sounding like inveterate
Pollyannas, we disagree. As we stressed in ‘Analytical,’ there is still much to be
learned about the quantitative dimensions and timing of the economy’s response
to fiscal-policy actions. But *he theoretical channels and qualitative effects of
fiscal policy seem relatively well established, at least as well established as any
piece of macroeconomic theory.
We have divided our response into several sections. In section 2 we bring our
views on the monetarist-Keynesian controversy up to date (circa spring 19X),
and try to put the contribution of ‘Does fiscal policy matter?’ into perspective.
Section 3 examines the puzzling results that Infante and Stein obtained with the
‘fiscalist’ model, and explains why we find them not so puzzling after all. In
section 4 we restate - more clearly, we hope - the message of ‘Does fiscal policy
matter ?,’ and show why we think the Infante-Stein critique misses the mark.
Our biggest disagreements are saved for section 5, where we examine the way in
which Infante and Stein relate the theoretical findings from ‘Does fiscal policy
matter?’ to the results of large-scale econometric models. We find the analysis
there at best misleading and at worst just plain wro::g*
are made, important issues remain unresolved. How large are the integers
Kand M? What is the height of the peak real multiplier? What is the ultimate
nominal multiplier? Since the economy is no doubt nonlinear, how do these
answers change with variations in initial conditions? The answers to these
questions make a great deal of difference. 3
The portions of our two papers which addressed themselves to the monetarist-
Keynesian controversy circa 1972 sought to demonstrate that those monetarists
who contended that fiscal policy actions had no long-run effect OIZaggregate
denmd were involved in a logical contradiction. We showed that either the long-
run effect is bigger than the short-run effect or the response of the economy is
explosive (in either direction). Zero effect is simply not a logical possibility.
The Infante-Stein critique does not refute this view. They are right, however,
to challenge our notion that the unstable case could be ruled out on logical
grounds. We must admit that a fair reader of our papers might come away with
the view that: ‘Since the economic system we observe seems to be stable, Blinder
and Solow necessarily conclude that the monetarist scenario cannot be cozect’
(Infante and Stein, p. 484). That was an error.
Infante and Stein are also correct to question the casual empiricism which
*established’ the stability condition
1-T’
FB > -
T’ ’
where Fs is the IS-LM multiplier effect of bonds (B) on real output (Y), and T’
is the marginal propensity to tax and reduce transfers as income rises.4 For one
thing, FB is not simply a transfer multiplier - a point Infante and Stein neglect
in their section 4. An increment in B has effects like a transfer payment through
the accompanying interest payments; but it also has wealth effects. Secondly,
interest on the national debo is taxable; most other transfers are not. Thirdly,
recipients of government interest payments mzy have much lower marginal
propensities to consume than recipients of other transfers. Finally, we no longer
believe that the empirical evidence supports our ‘guesstimate’ that T’ is at least
one-ha1 f.
All of this adds up to the admission that the size of Fu is a serious empirical
issue, not to be settled by our armchair speculation or anyone clse’s. It ma!’ well
be that (1) is reversed. In that case, a government which stubbornly refused to
finance budget imbalances at least partly by printing or destroyinr! rnonev could
destabilize an otherwise stable economy. We imagine that mosi poverin?ents
would not be so stubborn.
jNone of the evidence on the steepness and speed of adaptation of the long-run Phillips
curve is entirely convincing, and prevailing views may change as the recsnt rathe special
episode recedes.
40n this see Scarth (1976).
I)
504 A.S. Blinder and R.M. S’olow,Fiscal policy: A reply
%fante and Stein treat this as only one of uwo possible casts. There is also a stable case
where the marginal propensity to consume (MPC) is less than one but the sum of the MPC
and the marginal propensity to invest is greater than one. In this case, T’FG 3 1, SO that
government spending leads to budget surpluses and the long-run multipliers d Y/dG and
dB/dG are both negative. We do not find this case very interesting.
61nfante and Stein claim that our weighted standardized surplus concept ‘was analyzed on
the basis of such a fiscalist case’ (p. 485). In fact, we only used the fiscalist model as the
simplest possible illustratkl:, and observed that ‘the measure generalizes in an obvious way
to a-mmodate a model of arbitrary complexity” (‘Analytical’, p. 23).
A.S. Blinder and R. M. Solorv, Fiscal po hey: A rep/y 505
‘III expositing our rock-bottom model, Infante and Stein mistakenly say that we used the
spbol Y to denote nominal income. In fact, we used it for real income.
506 AS. Blinder and R.M. Solow, Fiscal policy: A reply
likely to be stable if deficits are financed by prhting money than if they are
@awed by -floating bonds. The second message is that the long-run e$?ct of
government spending on aggregate demand is greater when dejcits are bond-
jinanced that when they are money-financed. Both messages are logical con-
sequences of the fact that government bonds pay interest, while money does not.
Pnfante and Stein claim to have refuted these messages by ‘showing that the
stability of the rock-bottom model does not imply either the positivity of this
cumulative multiplier [the steady-state multiplier d Y*/dG] or that this multiplier
is larger when deficits are financed through the sale of bonds than when the
deficits are financed by the issuance of new money’ (p. 485). However, it takes
only a little algebra - actually provided by Infante and Stein in their footnote 6
(p. 487) - to show that d Y*/dG is both positive and bigger under bond-finance
than under money finance whenever the stability condition (1) is satisfied and
us (y#$-L.) > 0.
FG-’ exceeds T’because aL, > 0, and 0 < T’ < 1 imply that
1 -C1+d, > T’tl -Cl).
But, with government spending and taxes unchanged, a budget surplus results.
Either money or bonds must be retired to finince this’ surplus, and these actions
have a contractionary impact on aggregate demand. We know that the cumula-
tive contraction must overwhelm the initial expansion because the condition
for budget balance requires
government budget constraint [see Christ (1971)]. How, then, can they be used
to confirm or refute our theoretical notions?
Infante and Stein compare our theoretical notions to the findings of the
econometric models on five questions. They conclude that the models ‘do not
support the implications drawn by Blinder and Solow from the rock-bottom
model’ (p. 499). Let us examine each of these questions in turn.
Do Y and P react in the same direction ? The verdict of the models seems to be
%IO’- probably not in the short run and definitely not in the long run.
First, we would take issue with Infante and Stein’s identification of second-
quarter multipliers from econometric models with our ‘impact multipliers.’ Our
impact multipliers refer to a hypothetical scenario in which all the lags in the
IS-LM sector work themselves out, while P remains fixed. While P is nearly
unresponsive to G within two quarters, empirical consumption and investment
functions certainlv suggest that the IS-LM lags are far longer than two quarters.
Second, there is a transitory phenomenon that is always ignored by theoretical
modli:ls. Short-run surges in aggregate demand lead to productivity improve-
ments which hold down, and may even lower, prices. This is the reason why
dP;dG is negative for a few quarters in most econometric models. Third, most
econ,ometric moJe1 builders would admit that price-determination is one of their
weakest links. WJien Fromm and Klein wrote the article which Infante and Stein
use. killmodels were demand-oriented, and paid almost no attention to the supply
tide of the economy. In Wharton 111,for example, a stimulus to aggregate demand
wcrs prices for at least 4 years.
Do mh’pIicr paths reach appropriate hits? We would expect (see footnote 1)
both real and nominal values to show damped oscillations towards limiting
values which would be relatively small or zero for the former and substantially
positive for the latter.
Infante and Stein use 40.quarter multipliers (except for the MPS model) as
empirical representations of our theoretical long-run multipliers. It is well
known. however, that these econometric models are designed almost exclusively
for short-run analysis, and often exhibit unbelievable behavior if the computer is
allowed to whir away long enough. In our view, 40,quarter multipliers tell more
about the long-run behavior of difference-equation systems than they do about
the U.S. economy. This is why we restricted our examination of results from the
models to 12 quarters in ‘Analytical.’ We are, therefore, unimpressed by the fact
that 40-quarter simul Itions are at variance with our theoretical notions.
Despite this, let us look at the evidence. Infante and Stein have the most
trouble accounting for the real multipliers, dY/dG, which look bizarre by any-
one’s standards (see their table 3). What is going on here? Inspection of Fromm
and Klein’s table 5 shows that:
For the Brookings and DHL models, the simulations seem to be converging
toward zero or a small positive value.
AS. Blinder and R.M. Solow, Fiscal policy: A reply 509
(2) The MPS model after 16 quarters gives the appearance of convergence.
But those familiar with its properties know that it damps very slowly. If
allowed to run 40 quarters, it would probably still be cycling.
(3) DRI and Wharton show the behavior that MPS would have shown: cycles
which are either anti-damped or damp very slowly.
(4) The BEA model simulation looks as if the computer blew a fuse.
If we ignore the BEA model, these results do not look so bad after all.
In fact, they look better than they should, for most of the simulations reported
by Fromm and Klein were based on strstaind irtcrements ift nomitzalgovertfment
spetding. ‘Real multipliers’ were computed by dividing the observed change in
real GNP, quarter by quarter, by the observed change in real G. The latter falls
endogenously over time as the government deflator rises. So the ‘real multipliers’
refer to u /urge initial incwasc in G f~~/low~d by a wccession of smal! decreases.
It is no wonder, then, that such ‘multipliers’ may turn negative and take a long
time to damp down.
Does the stabiiitvI condition hold? Here Infante and Stein commit the same
error we did in our (futile) exercise in casual empiricism - trying to use an
empirical tax multiplier to represent FB. Furthermore, we repeat that two-quarter
econometric multipliers are not the same as our theoretical impact multipliers.
DWS art oplw-market purchasr raLw Y and P in the short mu ‘?Infante and
Stein, using some results tabulated by Christ (1975), find that Y generally rises
but P often falls. The explanation for this ‘perversity’ probably lies in the short-
run productivity gains cited earlier.
DWJ au opcmmarket ptrrchu.sc iowr Y arld P i/l th lotlg rrrlz ? Infante and
Stein find that most of the models imply that Y and P rise instead. Our reasons
for ignoring the 4O-quarter mllltipliers- of econometric models were explained
previously. lo But, even if these were waived, the fact remains that none of the
models contains the causal chain from budget imbalances to both future wealth
and future interest payments, which is what makes an open-market purchase
contractionary in our model.
6, Concludingcommeet
Infante and Stein give the distinct impression that there is no convergence of
views m the operation of fiscal policy. We think tl:,ere is convergence, on both
the empirical and theoretical levels. The c%ef concliusions of our two papers are
also implied by the Brunner and Meltzer model. When Blinder and Solow agree
with Brunner and Meltzer, is there not convergence of views? It is Aso our
l”T‘he monetary-policy simulations tabulated in Christ’s (1975) table 4 actually 1hSt 36
quarters in the DRI and MQEM model.,, 16 quarters in the Wharton, 14 quarters in the
Liu-Hwn(monthly) model, and 64 quarters in the Hickman-Coen (annual) model.
510 A.S. Blinder and R.M. solow, Fiscal policy: A reply
References
Blinder, A.S. and R.M. Solow, 1973, Does fiscal policy matter?, Journal of Public Economics 2,
319-337.
Blinder, A.S. and R.M. Solow, 1974, Analytical foundations of fiscal policy, in: A.S. Blinder
et al., The economics of public finance (Brookings, Washington, DC) 3-l 15.
Brunner, K. and A.H. Meltzer, 1976, An aggregative theory for a closed economy, in: J.L.
Stein, e&, Monetarism (North-Holland, Amsterdam) 69-103.
Christ, C.F., 1971, Econometric models of the financial sector, Journal of Money, Credit and
Banking 3, no. 2419-449.
Christ, C.F., 1975, Judging the performance of econometric models of the U.S. economy,
International Economic Review 16,54-73.
Fromm, G. and L.R. Klein, 1973, A comparison of eleven econometric models of the United
Sta?es, American Economic Review 63,385-393.
Infante, E.L. and J.L. Stein, 1976, Does fiscal policy matter?, Journal of Monetary Economics
2,473~500.
Scarth, WM., 1976,, A note on the ‘crowding out’ of private expenditures by bond-financed
increases in government spending, Journal od Public Economics, 5,385-387.
Stein, J.L., 1976, Monetarism (North-Holland, Amsterdam).
Tobin, J. and W.H. Buiter, 1976, Long-run effects of fiscal and monetary policy on aggregate
demand, in: J.L. Stein, ed., Monetarism (North-Holland, Amsterdam) 273-309.