David R. Henderson  

Scott Sumner on the Multiplier

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Multiply Scott Sumner

It seems to me that there are two ways of thinking about how monetary policy would react to fiscal stimulus. One approach would be to ask: "What is the optimal Fed response to fiscal stimulus?" And the answer to that question is rather obvious; the Fed should act in such a way as to completely neutralize the impact of fiscal stimulus, i.e. make sure the multiplier is precisely zero. This is because the Fed has some optimal level of expected AD growth in mind, and that level should not change just because fiscal policy changed. So if the Fed is doing its job, which means if it is always targeting expected AD growth at what it sees as the optimal rate, then it will try to completely offset fiscal stimulus and the expected fiscal multiplier will be precisely zero. That's why fiscal stimulus almost disappeared from graduate textbooks in recent years.

IMO, this is the most important paragraph in Scott Sumner's recent post on the multiplier. I had thought I had known what the Keynesian multiplier was but now I realize that I was considering only one case: the increase in nominal GDP due to an increase in nominal aggregate demand caused by an increase in government spending. But read his post to see how much actual confusion he uncovers in the debate.

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CATEGORIES: Fiscal Policy

COMMENTS (8 to date)
winterspeak writes:

Federal deficit spending (fiscal stimulus) funds net non-govt sector savings. If it is too small to fund that savings need, you see AD continuing to fall. If it is in excess of that savings need, you will see inflation.

Monetary policy, which merely rearranges the term structure of assets at the fund, has no impact. As we can see from the reality of the past 12 months. (Although I can be persuaded that zero interest rates are also sapping aggregate demand as they drain interest income from the non-Govt sector).

The "multiplier" is a fiction because bank lending is not reserve constrained, and that is all monetary policy tinkers with.

floccina writes:

but winterspeak am I wrong to think that the Fed can still buy assets and that as long they can buy treasury bonds they are not constrained in conventional monetary policy. Beyond treasuries there are other assets to buy like corporate bond stocks etc. It seems to me that there are plenty of ways to get money into the economy through monetary policy that will not create a huge debt for tax payers. Am I wrong?

Winterspeak writes:

Floccina: the fed is not a currency issuer unlike the treasury. The fed can alter the term structure of assets, and can take them onto it's balance sheet. But it cannot create pure bank reserves (paid in equity) the way the treasury does through fiscal deficit spending

look at it this way. Of you have more debt than you want, and cannot afford the det you have, you will not be interested in taking on additional debt via different instruments no matter the interest rate. What you want is to simply pay some of your debt down and only the treasury can help with that

aaron writes:

Or simply refinance your existing debt at current rates.

The mortgage industry is playing a dangerous game or chicken not offering current rates to existing debt. If the industry writes people off at 4%, why would they pay 6%.

Yancey Ward writes:


The Fed could buy my debt and burn the paper. Wouldn't that help me in the same way?

winterspeak writes:

YANCEY: Yup. What you're describing though is really a Treasury function, as the Fed can just swap one liability for another, it cannot extinguish liability. The Treasury would act through the Fed, as the Treasury uses the Fed as its bank.

This would be properly called "fiscal stimulus" and the stimulus recipient would be you.

Ritwik writes:

Winterspeak: Bank lending is not reserve constrained? Now, or always?

winterspeak writes:

Ritwik: Always.

You cannot say anything meaningful about the financial system in general, or this crises in particular without understanding that:

1. Bank lending is not (never) reserve constrained
2. The Federal Deficit funds net non-govt sector savings

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