Multipliers: The Very Sharp Greg Ip Gets One Wrong
In the Economist, he writes:
Much ado about multipliers: Different assumptions about the impact of higher government borrowing on interest rates and private spending explain wild variations in the estimates of multipliers from today’s stimulus spending. Economists in the Obama administration, who assume that the federal funds rate stays constant for a four-year period, expect a multiplier of 1.6 for government purchases and 1.0 for tax cuts from America’s fiscal stimulus. An alternative assessment by John Cogan, Tobias Cwik, John Taylor and Volker Wieland uses models in which interest rates and taxes rise more quickly in response to higher public borrowing. Their multipliers are much smaller. They think America’s stimulus will boost GDP by only one-sixth as much as the Obama team expects. When forward-looking models disagree so dramatically, careful analysis of previous fiscal stimuli ought to help settle the debate...
No analysis of previous fiscal stimuli will settle the debate. The multiplier--if the Federal Reserve keeps the federal funds rate pegged near zero--is 1.6. If the Federal Reserve decides that that fiscal stimulus is leading to a danger of rising inflation, it will raise interest rates to offset the effect of increased spending. To say that the multiplier is only 1/6 as large in Cogan, Cwik, Taylor, and Wieland is misleading: depending on what assumptions you make about Federal Reserve behavior, the "multiplier" they calculate would vary between 1.6 and 0.
The best way to phrase it is that the multiplier is 1.6--unless fiscal stimulus leads the Federal Reserve to fear inflation, in which case it will take action to cut the multiplier down to whatever value it wishes. The decisive point is that if the Federal Reserve doesn't take action to cut the multiplier below 1.6, we will really wish we had undertaken an even bigger fiscal stimulus. And if the Federal Reserve does take action to cut it down, we won't be too upset at having (temporarily) cut taxes, raised transfers to states, and spent some money on infrastructure.
