WORKING PAPER SERIES NO 1090 / SEPTEMBER 2009 NEW KEYNESIAN VERSUS OLD KEYNESIAN GOVERNMENT SPENDING MULTIPLIERS by John F. Cogan, Tobias Cwik, John B. Taylor and Volker Wieland WORKING PAPER SERIES NO 1090 / SEPTEMBER 2009 NEW KEYNESIAN VERSUS OLD KEYNESIAN GOVERNMENT SPENDING MULTIPLIERS 1 by John F. Cogan 2 , Tobias Cwik 3 , John B. Taylor 4 and Volker Wieland 5 In 2009 all ECB publications This paper can be downloaded without charge from feature a motif http://www.ecb.europa.eu or from the Social Science Research Network taken from the €200 banknote. electronic library at http://ssrn.com/abstract_id=1468262. 1 The views expressed in this paper are those of the authors and do not necessarily reflect those of the European Central Bank or the Eurosystem. 2 Stanford University – The Hoover Institution on War, Revolution and Peace, HHMB Rm 347, Stanford, CA 94305, USA; e-mail: [email protected] 3 Goethe University Frankfurt, Grüneburgplatz 1, Uni-Pf. 77, D-60323 Frankfurt am Main, Germany; e-mail: [email protected] 4 Stanford University, Stanford, CA 94305, USA; e-mail: [email protected] 5 University of Frankfurt, P.O. Box 94, Mertonstrasse 17, D-60054 Frankfurt am Main, Germany; e-mail: [email protected] © European Central Bank, 2009 Address Kaiserstrasse 29 60311 Frankfurt am Main, Germany Postal address Postfach 16 03 19 60066 Frankfurt am Main, Germany Telephone +49 69 1344 0 Website http://www.ecb.europa.eu Fax +49 69 1344 6000 All rights reserved. Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the author(s). The views expressed in this paper do not necessarily refl ect those of the European Central Bank. The statement of purpose for the ECB Working Paper Series is available from the ECB website, http://www.ecb.europa. eu/pub/scientific/wps/date/html/index. en.html ISSN 1725-2806 (online) CONTENTS Abstract 4 Non-technical summary 5 1 Introduction 7 2 The need for an alternative assessment 9 3 The problem with an interest rate peg 10 4 Government spending multipliers: new Keynesian versus old Keynesian 11 5 Alternative assumptions about monetary policy 13 6 A more realistic path for government purchases 14 7 Estimated impacts 17 8 Impacts of an entire U.S. stimulus package 20 9 Conclusion 23 References 24 Acknowledgement 25 European Central Bank Working Paper Series 26 ECB Working Paper Series No 1090 September 2009 3 Abstract Renewed interest in fiscal policy has increased the use of quantitative models to evaluate policy. Because of modelling uncertainty, it is essential that policy evaluations be robust to alternative assumptions. We find that models currently being used in practice to evaluate fiscal policy stimulus proposals are not robust. Government spending multipliers in an alternative empirically-estimated and widely- cited new Keynesian model are much smaller than in these old Keynesian models; the estimated stimulus is extremely small with GDP and employment effects only one- sixth as large. Keywords: Fiscal Multiplier, New Keynesian Model, Fiscal Stimulus, Government Spending, Macroeconomic Modeling JEL Classification: C52, E62 ECB Working Paper Series No 1090 4 September 2009 Non-Technical Summary A recent paper by Christina Romer and Jared Bernstein provides numerical estimates of the impact of an increase in government spending on GDP and employment in the United States. They state that their estimates are based on two particular quantitative macroeconomic models – one from the staff of the Federal Reserve Board and the other from an unnamed private forecasting firm. By averaging the impacts generated by these two models, they calculate that an increase in government purchases of 1 percent of GDP would induce an increase in real GDP of 1.6 percent compared to what it otherwise would be. On this basis, they predict that a stimulus package of similar magnitude as the American Recovery and Reinvestment Act (ARRA) of February 2009 would increase output by 3.6 percent by the fourth quarter of 2010 and create or save about 3 1/2 million jobs. Macroeconomists remain quite uncertain about the quantitative effects of fiscal policy. This uncertainty derives not only from the usual errors in empirical estimation but also from different views on the proper theoretical framework and econometric methodology. Therefore, robustness is a crucial criterion in policy evaluation. Robustness requires evaluating policies using other empirically-estimated and tested macroeconomic models. In this paper, we consider two such models for comparison, the multi-country model of Taylor (1993) and the model of the U.S. economy by Smets and Wouters (2007). Both models allow for an important role of nominal rigidities in price and wage-setting, but also account for forward-looking behavioural decision making by households and firms. Thus, they can be characterized as New-Keynesian macroeconomic models. In these models, households and firms consider the implications of fiscal stimulus on future taxes and interest rates. Consequently, expectations of lower wealth and higher funding costs dampen private sector economic activity. ECB Working Paper Series No 1090 September 2009 5 We consider more realistic assumptions regarding the likely paths of interest rates. Contrary to Romer and Bernstein, who assume that the nominal interest rate remains pegged, our analysis allows for the return to a stabilizing monetary policy after one or two years. Finally, we consider a more realistic path of government expenditures. While Romer and Bernstein assume a permanent increase in government spending, we assess the time path of the additional government expenditures planned for in the ARRA, and evaluate the effect of households’ and firms’ anticipation of this future spending. Our estimates obtained with the model of Smets and Wouters (2007), which is a typical current New-Keynesian model, suggests that the likely GDP impact of the fiscal stimulus measures is only 1/6 of the estimates presented by Romer and Bernstein. ECB Working Paper Series No 1090 6 September 2009 1. Introduction In a recent paper1 Christina Romer and Jared Bernstein provided numerical estimates of the impact of an increase in government spending on GDP and employment in the United States. Such estimates are a crucial input for the policy making process. They help determine the appropriate size and timing of countercyclical fiscal policy packages and they help inform members of the Congress and their constituents about whether a vote for a policy is appropriate. For packages approaching $1 trillion including interest, as in 2009, the stakes are enormous. The estimated economic impacts matter. The Romer-Bernstein estimates are based on two particular quantitative macroeconomic models – one from the staff of the Federal Reserve Board and the other from an unnamed private forecasting firm. By averaging the impacts generated by these two models, they estimate that an increase in government purchases of 1 percent of GDP would induce an increase in real GDP of 1.6 percent compared to what it otherwise would be. Their results are shown in Figure 1. Also shown in Figure 1 are the estimated effects of exactly the same policy change—a permanent increase in government purchases—as reported in another study published a number of years ago.2 It is clear from Figure 1 that the results are vastly different between the different models. Perhaps the most important difference is that in one case higher government spending keeps on adding to GDP “as far as the eye can see,” while in the other case the effect on GDP diminishes as non-government components are crowded out by government spending. 1 See Romer and Bernstein (2009), Appendix 1, page 12. The paper was written in early January 2009 during the transition period just before Christina Romer was sworn in as Chair of the Council of Economic Advisers and while Jared Bernstein was Chief Economist of the Office of the Vice-President. 2 See Taylor (1993), Figure 5-8A, page 166. This is a rational expectations model with staggered wage and price setting and thus could be described as “new Keynesian” as defined below. ECB Working Paper Series No 1090 September 2009 7 percent change 1.6 Romer-Bernstein (2009) 1.4 1.2 1.0 0.8 0.6 0.4 0.2 Taylor (1993) 0.0 2009 2010 2011 2012 2013 2014 Figure 1. Estimated Impact on GDP of a Permanent Increase in Government Purchases of 1 percent of GDP Macroeconomists remain quite uncertain about the quantitative effects of fiscal policy. This uncertainty derives not only from the usual errors in empirical estimation but also from different views on the proper theoretical framework and econometric methodology. Therefore, robustness is a crucial criterion in policy evaluation. Robustness requires evaluating policies using other empirically-estimated and tested macroeconomic models. From this perspective Figure 1 raises concerns because the Romer-Bernstein estimates are far different from existing published results of another model. For these reasons an examination of whether the Romer-Bernstein results are robust to different model and policy assumptions is in order. ECB Working Paper Series No 1090 8 September 2009 2. The Need for an Alternative Assessment We think it is best to start by conducting a fresh set of simulations with a macroeconomic model other than one of those used in Figure 1. We focus on the Smets- Wouters model of the U.S. economy.3 The Smets-Wouters model is representative of current thinking in macroeconomics. It was recently published in the American Economic Review and is one of the best known of the empirically-estimated “new Keynesian” models. It is very similar to, and “largely based on” according to Smets and Wouters, another well-known empirically-estimated new Keynesian model developed by Christiano, Eichenbaum and Evans (2005).