It is not clear that the estimates of “local multipliers” made by Nakamura and Steinnson (2011) and an increasing number of others estimate a policy-relevant aggregate multiplier--even though such work does come closest of all to performing that task. Examining differences in government spending across regions with a common currency and financial structure, it identifies a multiplier holding constant monetary and financial conditions. This literature appears to be coalescing around an estimate of a constant-monetary-and-financial-conditions multiplier of 1.5.
However, such estimates of the multiplier based on comparisons of localities that benefit from more and less federal spending abstract from any aggregate effects of spending on future tax liabilities, confidence, or the risk premium component of interest rates. They study regions, where demand effects are very likely to be attenuated by spillovers, for regions are more open economies than the United States or the North Atlantic.
Thus uneasiness about the interpretation of local multiplier results remains. First, the presence of demand spillovers across regions means that such estimates are likely to underestimate of policy-relevant zero bound multipliers in less-open na-tional economies. Second, a channel of transmission may be higher expected inflation rates, in the manner of Christiano, Eichenbaum, and Rebelo (2011), and Eggertsson and Krugman (2011). To the extent that the multiplier is large because financial conditions in the form of expected inflation are not the same in the counter-factual as in the baseline, local multiplier estimates will undershoot.
Third, consider a permanent increase in government purchases in one region fi-nanced by taxes on all regions. Under a full Ricardian régime, such a permanent increase in spending will have no effect at all on demand and output: public demand rises, and private demand falls by the same amount. However, the public demand will be concentrated in the one region where the spending takes place. That region will thereafter have a higher relative intensity of economic activity, and ultimately more factors of production will choose to locate there.
Yet a local multiplier study would then show a considerable multiplier in both the short and the long run.
In the long run, the multiplier estimated with the local multiplier methodology would be an economic-geography parameter: the inverse of one minus the share of regional demand spent on locally-produced commodities. But in the postulated Ricardian setup that large estimated local multiplier would coexist with a situation in which expansionary fiscal policy had no impact on economy-wide aggregate demand. As Mendel (2012) points out, local multiplier studies not only hold constant monetary and financial conditions, they also hold constant future fiscal conditions in the form of expectations of future broad-based taxes. To the extent that the argument against the effectiveness of expansionary fiscal policy is an argument that relies on present-day reductions in spending stemming from anticipated future tax burdens, local multiplier studies will miss this channel as well...