Unit 4.3 effects of fiscal policy: the value of the multiplier

Question 1

The Keynesian model

Answer 1

1. Price stickiness -> in the short term -> equilibrium is reached through changes in quantity
2. Aggregate supply of goods and services is elastic -> aggregate demand movements determine output
3. No crowding-out effect -> that is private spending’s response does not offset the increase in public spending

Question 1

The Keynesian multiplier

Answer 1

Suppose the government increases public spending by 1$
- This will increase output, and thus income distributed to households, by 1$.
- Out of this additional unit, 80 cents will be consumed and will increase output (thus disposable income) again and again

Question 2

Factors that lower the Keynesian Multiplier

Answer 2

1. Taxes
2. Imports - in an open economy, households will make part of their consumption abroad
3. If prices adjust upward (and they will as time passes), part of the increase in demand does not result in an increase of the volume of products consumed, but in an increase in their price.
4. The central bank may respond to an increase demand for products by an increase in r -> crowding out effect: investment from firms declines because they compare the yield of investment projects to the finance cost or with the return to financial investments

Question 3

Ricardian equivalence

Answer 3

if households anticipate future economic changes (like booms and busts), they adjust their current spending and saving. For example, they might borrow during recessions and save during expansions, knowing that their total income over time remains the same. This behavior implies that government intervention (like increasing spending) might not be necessary for economic stabilization and could even be counterproductive, (as it leads to higher future taxes, reducing private spending).

Question 4

criticism of Ricardian equivalence

Answer 4

Assumption - argument

1. Rational expectations - few households understand the complex math of intertemporal public finances
2. Infinitely lived consumers - many have short horizons
3. The unproductive character of public expenditure - some public expenditures have positive effects on future incomes
4. The absence of credit constraints - a large part of them is constrained by credit

Question 5

Estimating the impact of fiscal policy - approaches

Answer 5

1. Simulations with macroeconomic models
   pro: can account for various transmission channels and response variables
   con: they are very model-dependent
2. Empirical estimates with reduced forms
   pro: they rely on few assumptions
   con: they are comparatively rough
3. Systematic analysis of fiscal action episodes
   pro: it allows the multiplier to be non-constant across fiscal policy initiatives because agents expectations change
   con: needs to find significant and lasting fiscal episodes