Fiscal Policy

I have not taught fiscal policy in my principles classes for some time.  There seemed little need.  My reading of the macroeconomics literature was that the efficacy of fiscal policy was limited to the rare occurrence of a deep and long recession.  Based on the length of the Great Moderation, a period of low inflation, strong economic growth and high employment, I believed that monetary economists working inside the Federal Reserve had learned to better manage the business cycle.

A recession began when the housing bubble burst in 2007, straining our highly leveraged financial sector.  The economy headed south, leaving the desiccated memory of the Great Moderation in the dust, and beginning what many have termed the Great Recession, both long and deep, the conditions required for effective fiscal policy.

Fiscal policy is the sue of the federal government's taxing and spending authority to achieve or maintain full employment or price stability.  In times of recession, the government creates or enlarges deficits to maintain aggregate demand, the total level of demand for all goods and services throughout the economy.  Policy makers can cut taxes, increase spending or some combination of the two to reach desired deficits.  The additional spending by the government or recipients of tax cuts has a multiplied impact through the economy.  For example, Ben gets a $100 tax cut which he uses to buy a new Sony DVD player.  Sony uses the extra money to buy $90 of labor.  The $90 of wages buys $80 of groceries and so on. 

All theories are just good stories until empirically verified.  The focus of the empirical debate has turned on the size of the multipliers.  Multipliers greater than one stimulate growth while those less than one restrain growth.  Robert Barro and Charles Redlick describe the literature on empirically estimated multipliers as "thin" in "Macroeconomic Effects from Government Purchases and Taxes," NBER Working Paper No. 15369.  The authors estimate the multiplier at .7 when the economy is experiencing unemployment of 5.6%.  It increases .1 for every 2% increase in unemployment, implying that stimulus spending becomes beneficial (multiplier greater than 1) when the economy is experiencing 12% or greater unemployment.  In a Wall Street Journal article (Stimulus Spending Doesn't Work) that presents their findings, they conclude,

The bottom line is this: The available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. Defense-spending multipliers exceeding one likely apply only at very high unemployment rates, and nondefense multipliers are probably smaller. However, there is empirical support for the proposition that tax rate reductions will increase real GDP. 

Barro and Redlick have not given the final word on multipliers but their research is a good starting point for evaluating the effectiveness of fiscal policy and the size of multipliers
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