The Triangle

Issue date: 10/23/09 Section: Ed-Op

Media Credit: Nancy Stone Chicago Tribune/MCT Campus

There is strong ongoing debate about the size of the fiscal spending multiplier because the size represents the effectiveness of fiscal policy. This debate was generated by the controversy over the effectiveness of (or lack of) the Obama administration's fiscal stimulus. Both academics and policy makers find the debate very interesting and useful because the U.S. economy is in a zero-interest rate bound (known as liquidity trap) in which monetary policy is ineffective. Since interest rate could not go down any further, the Fed used unconventional monetary policy by buying assets instead of Treasury bills to stimulate the economy. Contrary to the conventional one, this policy is cumbersome and very expensive. Paul Krugman said it takes $1 to $1.6 trillion of buying assets to accomplish what 1 percent decline in interest rate can accomplish. Goldman Sachs estimated that to get the economy out of the current recession, it requires that interest rate goes down to negative 6 percent (by the end of 2010) as suggested by Taylor's rule. This means unconventional monetary policy should buy $6 to $9.6 trillion of assets to complete the job. This is a colossal increase in the Fed's balance sheet, and I am not sure if this is feasible from start to finish.

This is why the debate has refocused itself on the size of the fiscal spending multiplier. Many estimates have been given to this multiplier, ranging from zero to 2 percent. Recent research suggest that the fiscal multiplier is more completed than what's described in academic textbooks and op-eds in newspapers. Pundits who send their comments to newspapers focus the stage of the business cycle to differentiate between the possible sizes of the multipliers. For example, Robert J. Barro and Charles Redlick (2009) presented the view that the size of the multiplier depends on the state of the economy. In a recent Wall Street Journal op-ed, they estimated that their research finds the relationship between the size of the multiplier and the increase in the unemployment rate above the 5.6 percent long-run median rate to be 0.1 increase in the multiple for a 2 percent an increase in the unemployment rate. According to this estimate, the unemployment rate should go to 12 percent for the multiplier to go above 1. On the other hand, Chair of President Obama's Council of Economic Advisers Christina Romer (2009) estimated the multiplier to be 1.6. This is basically the number I suggested in my own op-ed that I posted last March.

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