“One thing that’s been bothering me about the discussion over fiscal stimulus is the virtual absence of fully worked-out models, with all their t’s dotted and eyes crossed, or something.”
What I want to do in this note is sketch out a New Keynesian-type analysis of the role of fiscal policy in a liquidity trap. The bottom line is quite striking: aside from some qualifications when the economy is in a liquidity trap government spending should expand up to the point at which full employment is restored.
The basic intuition behind this result is that when the economy is in a liquidity trap, the social marginal cost of government spending is low, because there isn’t enough private demand to fully employ the economy’s resources. This means that we would normally expect more government spending to raise welfare, right up to the point that full employment is restored. At that point the marginal cost of government spending jumps up, because it’s diverting resources from private spending.
The bottom line here is that while we usually think of Keynesianism as the preserve of ad hoc models, in this case doing it “right”, using a macromodel with maximizing agents and a proper concern for intertemporal constraints, actually suggests a very strong case for big government spending in the face of a liquidity trap. When the economy is depressed and monetary policy can’t set it right, the true opportunity cost of government spending is low. So let’s get those projects going.
Not everyone agrees especially the Austrians as we pointed out in the blog with Peter Schiff from EuroPac.
William Anderson, Ludwig Von Mises Institute writes “as a long-time critic of the part-time economist and full-time political partisan Paul Krugman I am required to add that a broken clock is still more consistent at telling time than Krugman is at explaining economic phenomena”. Ouch
Rolfe Winkler Option Armageddon says "Naturally, he says nothing about where this money is supposed to come from. Regular readers of this blog know there are only two places the money can come from: taxpayers or the printing press. His column deserves to be taken apart piece by piece."
Don't you just love it when intellects clash.
Peter Schiff : First the Germans. then the church, now the Austrians attack
What I want to do in this note is sketch out a New Keynesian-type analysis of the role of fiscal policy in a liquidity trap. The bottom line is quite striking: aside from some qualifications when the economy is in a liquidity trap government spending should expand up to the point at which full employment is restored.
The basic intuition behind this result is that when the economy is in a liquidity trap, the social marginal cost of government spending is low, because there isn’t enough private demand to fully employ the economy’s resources. This means that we would normally expect more government spending to raise welfare, right up to the point that full employment is restored. At that point the marginal cost of government spending jumps up, because it’s diverting resources from private spending.
The bottom line here is that while we usually think of Keynesianism as the preserve of ad hoc models, in this case doing it “right”, using a macromodel with maximizing agents and a proper concern for intertemporal constraints, actually suggests a very strong case for big government spending in the face of a liquidity trap. When the economy is depressed and monetary policy can’t set it right, the true opportunity cost of government spending is low. So let’s get those projects going.
Not everyone agrees especially the Austrians as we pointed out in the blog with Peter Schiff from EuroPac.
William Anderson, Ludwig Von Mises Institute writes “as a long-time critic of the part-time economist and full-time political partisan Paul Krugman I am required to add that a broken clock is still more consistent at telling time than Krugman is at explaining economic phenomena”. Ouch
Rolfe Winkler Option Armageddon says "Naturally, he says nothing about where this money is supposed to come from. Regular readers of this blog know there are only two places the money can come from: taxpayers or the printing press. His column deserves to be taken apart piece by piece."
Don't you just love it when intellects clash.
Peter Schiff : First the Germans. then the church, now the Austrians attack
Paul Krugman : Optimal Fiscal Policy in a liquidity trap (ultra wonkish)
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