The Great Multiplier Debate

Menzie Chinn at Econbrowser comments on a post by Greg Mankiw, who cites a study by Cogan, Cwik, Taylor, and Wieland that suggests that fiscal multipliers are small, especially when considering New Keynesian models. According to the authors:

We first show that the assumptions made by Romer and Bernstein about monetary policy -- essentially an interest rate peg for the Federal Reserve -- are highly questionable according to new Keynesian models. We therefore modify that assumption and look at the impacts of a permanent increase in government purchases of goods and services in the alternative model. According to the alternative model the impacts are much smaller than those reported by Romer and Bernstein.

Cogan et al. use a New Keynesian dynamic stochastic general equilibrium (DSGE) model. Chinn then contrasts these results to result obtained from the IMF's New Keynesian DSGE (The Case for Global Fiscal Stimulus).

...the effect on U.S. GDP of investment expenditures is 3.9 when there is global fiscal expansion and only 2.4 when the United States acts alone. Similarly, the effect on Japanese GDP of targeted transfers is 1.5 when there is global fiscal expansion and only 1.0 when Japan acts alone. Differences in multipliers across regions relate to the size of leakages in the different areas, including leakages into saving and imports.

Chin then asks "The obvious question -- why the disjuncture? They're both New Keynesian DSGEs?" , and provides an explanation:

I think New Keynesian DSGEs -- like any other large models incorporating many equations -- can yield differing results depending on the assumptions made, some of which might seem inconsequential or conventional; what I have in mind include those assumptions regarding the nature of asset markets..... (j)ust because a model has microfoundations, intertemporal optimization, model consistent expectations, and so forth, doesn't mean it necessarily provides more plausible estimates. It matters what assumptions are made (is "complete asset markets" a good assumption, for instance? And if they were three years ago, are they still now? And I'll bet the proportion of "rule of thumb consumers" or "liquidity constrained consumers" is probably higher now than three years ago...).

What do "complete assets markets" have to do with fiscal policy effectiveness? If asset markets are imperfect, in that some households would like to borrow but cannot find credit, then these households will adjust consumption to temporary changes in lump sum payments. As I suggested in a previous post, as borrowing constraints will have the largest impact on those closest to the constraint, it is no suprise that lump sum payments targeted to relatively poor households tend to exhibit relatively larger multipliers. It is precisely these households that tend to exhibit rule-of-thumb consumption behaviour, as opposed to consumption consistent with the permanent income hypothesis.