Q&A: Why is Fiscal Policy So Close to Being Neutral in Many Modern Macro Models?

Q: Hi Miles: Sorry to bother you, but I’ve gotten hornswoggled into teaching macro again and there is one topic in kind of the evolution of macro that is eluding me.

And that question is, how did we get to fiscal policy irrelevance/ineffectiveness in the new keynesian dynamic model?

Is it a presumed Fed response to offset? Is it Ricardian Equivalence? Is it just that VARs show little response?

Can you give me a pointer about where to look?

A: This is something I teach in my graduate macro class. Fiscal policy irrelevance has nothing to do with sticky prices or not. It is all about investment. Without investment frictions, investment tends to be crowded out 1 for 1 by government purchases in both sticky-price and non-sticky-price models. (Let me ignore the effects on labor supply because of the impoverishment caused by higher G and also the opposite-direction effects of higher marginal taxes to pay for the higher G.) And that logic should extend to sticky wage models as well. Sticky prices don’t matter because aggregate demand doesn’t even go up. G up, I down.

Q-theory affects this in a different way than many people probably think. Q-theory is not really investment adjustment costs, it is investment smoothing, analogous to consumption smoothing. So it is totally forward looking. If a shock is going to last 4 or 5 years, then there is still fairly complete crowding out of investment

I think you will like my (unpublished) paper with Susanto Basu on investment planning costs. Here are its slides. (These are totally public.) But planning adjustment costs only let G stimulate the economy for 9 months are so (the same as the lag in the effect of monetary policy that comes from planning adjustment costs). I call that period of time the ultra-short run.

To the extent it seems that government purchases do have an affect on output longer than the ultra-short run, to me the leading candidates are:

  1. Monetary policy response. For example, when more military spending is needed as in Ramey and Shapiro, the central bank may be accomodative. This is speculative, I don’t know it to be true.
  2. Imperfect mobility of labor between production of capital and production of G. This is more credible in some areas than others. For example, building a government office building and a private office building should be doable by the same factors, so those shifts of factors between G and I should be easy. But the government has many other purchases of products of types that would be unusual in the private sector. 

If fiscal policy is about tax cuts to increase C, there are the usual permanent income issues plus the issue of how easily C can crowd out I. But consumption smoothing is likely much stronger than investment smoothing a la Q-theory, so that probably does work, as implicitly assumed in my paper “Getting the Biggest Bang for the Buck in Fiscal Policy” in arguing for the greater effectiveness of credit policy.  

Our Michigan PhD Chris Boehm has a paper on all of these issues that you should look at. 

One reason I call myself a Monetarist rather than a New Keynesian is because of these issues with fiscal policy.