Menzie Chinn provides an excellent summary of arguments that a fiscal stimulus will have no effect on GNP. He charitably doesn’t mention the deduction from an accounting identity. I can’t resist arguing against the arguments which he lists.
Click the link to find the arguments.
Excellent summary. I think that there is one important practical observation which might be added. Cases 2 and 3 assume non-accommodating monetary policy. At the moment this is very unrealistic. The FED is clearly pedal to the metal. An increase of safe short term nominal interest rates would be countered by the FED. I don’t see how a fiscal stimulus can reduce expected inflation so I don’t see how it could cause increased real interest rates either.
Case 4 implies that a fiscal stimulus would make things worse (since they are assumed to be perfect now). However, it is just not true that it would have 0 effect on output. In particular increased Government consumption would crowd out consumption for fixed labor supply. This should cause increased labor supply. Case 4 requires market clearing *and* exogenous labor supply. It is not consistent with real business cycle theory in which labor supply is endogenous. The model with market clearing and fixed labor supply is presented in textbooks just as a step towards a model with unemployment or a model with elastic labor supply — no one takes it seriously as a model of the business cycle.
Again in case 5, if there is Ricardian equivalence tax cuts have no effect on GNP but increased G can have an effect on GNP by crowding out private consumption and increasing labor supply. This can cause GNP to increase even if there is unemployment if matching of the unemployed and vacant jobs is not perfectly efficient which it isn’t.
update: Ooops silly me. Case 5 is plainly nonsense as explained by PGL here.
Suppose we decide to have an additional $100 billion in public investment in 2009. In Ricardo’s example, permanent taxes will increase by $5 billion per year which would have a very modest offsetting reduction in consumption. So if government purchases rise by $100 billion and consumption falls by $5 billion, then isn’t the direct impact on aggregate demand closer to $95 billion for the year rather than zero?
PGL links to Kevin Quinn who noted the error in the Wikipedia
I vaguely recalled that, while Ricardian equivalence implies that tax cuts do not stimulate GNP, even if there is Ricardian equivalence increased Government spending does cause increased GDP. I also recalled that Paul Krugman presented a model of optimal stimulus when in a liquidity trap in which Ricardian equivalence holds. However, my case above against case 5 is totally feeble compared to PGL’s simple obvious point that the debt built up by increased government spending would be counted by a rational forward looking representative consumer by subtracting it from her wealth, a stock, while the spending is a flow. Under standard assumptions this rational representative consumer typically spends around 5% of her total wealth per year (equal to the rate of time preference) so the stimulus is 95% as effective as it would be if people ignored their share of the national debt. The timing of taxes doesn’t matter to a rational representative consumer, so this is true whether or not the spending is deficit financed or tax financed. Thanks PGL.
Quinn also made a good point in a comment on PGL’s post
kevin quinn said…
Further, suppose it’s not for war but for public investment with a greater rate of return than 5%. Then our permanent income is higher, so consumption will increase along with G!
Indeed. PGL’s calculation assumes that government spending is pure waste. The cost to taxpayer consumers will be lower (and may be negative) if the government spending is productive investment, like, you know infrastructure.
Thanks Kevin Quinn too.
So really the cases are down to case 1 and the question is “is the velocity of money constant ?”.
All empirical estimates say no.