Is Fiscal Pollcy useful in addressing Recessions?

The evergreen topic is visited once again by FRBSF economist Sylvain Leduc in this excellent short paper. The author says:

Should fiscal policy be used to fight recessions? Most economists would answer that, for normal economic ups and downs, business cycle stabilization should be left to monetary policy and that fiscal policy should focus on long-term goals. The main argument is that monetary policy can act quickly when output falls below an economy’s potential or when inflation varies from its optimal rate, and that these actions can be reversed quickly as conditions change. By contrast, modifications to the fiscal code take a long time to enact and implement and can be very difficult to undo.

However, the current recession is clearly not a typical downturn. In particular, unlike other post-World War II U.S. recessions, monetary policy has run out of its usual ammunition to boost economic activity.

Because of the severity of the recession and the uncertain effects of unconventional monetary policy tools, Congress and the Obama Administration have also enacted a fiscal stimulus package. The $787 billion program approved by Congress in February includes a mix of tax and spending measures aimed at creating jobs and boosting output. Yet, economists and political leaders heatedly debate whether tax cuts or increased spending are more effective, a dispute that’s hard to resolve because of the difficulty of determining the precise magnitude of fiscal policy’s impact on real GDP.

So what does fiscal multiplier imply theoretically?

Basic Keynesian theory suggests that the effect of a change in fiscal policy on real GDP is more than one-for-one. For instance, since government spending is one component of GDP, an increase in government purchases, by putting idle resources to work, boosts income one-for-one when the money is initially spent. In addition to that, though, since consumption is a function of current after-tax income in this framework, households also increase their consumption in line with their higher incomes, multiplying the effect of the initial government spending on GDP. The “multiplier effect” of government spending on GDP is thus greater than one.

This simple framework also predicts that the multiplier effect of a tax cut on GDP will be less than that for government spending. This is because a change in government spending affects GDP one-for-one, while part of a tax cut will be saved and will, at least initially, translate into a less than one-for-one increase in GDP.

However, the lit review suggests the opposite:

An interesting aspect of this new literature is that, notwithstanding their vastly different methodologies, they reach surprisingly similar conclusions. Regarding the impact of tax cuts on the level of real GDP one year after the change in taxes, the three studies predict a multiplier of roughly 1.2, as shown in Table 1.

 Moreover, Table 2 shows that, in contrast to theoretical predictions from the simple Keynesian framework, the analyses found that government spending had less bang for the buck than tax cuts. For instance, one year after the increase in spending, the impact on the level of real GDP is less than one-for-one, partly reflecting a decline in investment.

There is more disagreement, however, about the effects of tax cuts on output two years after they are implemented, as Table 1 indicates. The analyses of Romer and Romer and Mountford and Uhlig find very large tax multipliers, while Blanchard and Perotti continue to find effects similar to those occurring after one year.

🙂 Tyler Cowen had asked in his blog:

It’s about the influence of empirical economics:

I’d like one example, please. One example, from either micro or macro where people had to give up their prior beliefs about how the world works because of some regression analysis, ideally usually instrumental variables as that is the technique most used to clarify causation.

I will cite a few possible examples, although I won’t stick with instrumental variables:

I really do not know whether it is accepted within academia that tax cuts work better than govt expenditure after seeing empirical literature. I think it is still a controversial issue. But the evidence Leduc points in the above paper leans towards the list Cowen points to.

Superb insights. The question however still remains why is it so?

2 Responses to “Is Fiscal Pollcy useful in addressing Recessions?”

  1. Anchoring fiscal expectations is as important « Mostly Economics Says:

    […] policy usually about the various fiscal multipliers (whether higher with taxes or expenditures), impact in recessions etc etc. Why isn’t there adequate research on fiscal policy instiutions? On their […]

  2. Today’s economy media pack – 2009.06.26 | Says:

    […] Mostly Economics. Is fiscal policy useful in addressing recessions? “I really do not know whether it is accepted within academia that tax cuts work better than government expenditure after seeing empirical literature. I think it is still a controversial issue.” […]

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