Five Reasons Why Fiscal Policy Might Be Completely Ineffective: A Textbook Exposition

It’s been frustrating to me that so much virtual ink has been spilled about why the fiscal package will or will not be effective, with so little clarity. Lots and lots of words are being thrown around, [1] [2] when a lot of the arguments can be summarized pretty easily in terms of four cases, and hence four graphs (I won’t deal with the fifth, in detail). There are numerous excellent critiques; here in the interest of specificity, the exposition will be fairly dense.

1. With prices predetermined, the interest sensitivity of money demand is zero, or the income sensitivity of money demand is infinite.

2. With prices predetermined, the interest sensitivity of investment or the sensitivity of net exports to interest rates are infinite.

3. With prices predetermined, the sensitivity of money demand to wealth is high.

4. Output is at full employment levels.

5. Neo-Ricardian equivalence, as put forward by Barro, holds.

I’m going to use standard graphs from a standard macro textbook (Hall and Papell) in Figures 1 and 2. These rely upon the Hicksian decomposition that assumes that one can model the flow equilibrium in the real side of the economy and the stock equilibrium in the financial/asset side of the economy, or the framework otherwise known as the IS-LM model.Consider case 1 (“funky” money demand behavior): If the interest sensitivity of money demand is 0, then the LM curve is vertical, so as spending rises (shown by the gray arrow) and drives up money demand, interest rates have to rise sufficiently to as to reduce investment so that output is back to the original level; or the income sensitivity of money demand is infinite so that as soon as output rises money demand rises infinitely so interest rates have to rise so much as to reduce output back to the original level. I don’t know of any studies that suggest these parameters are plausible.fiscal1.gifNote: k is the income sensitivity of money demand, -h is the interest sensitivity of money demand, μ is the constant in the money demand equation, b is the marginal propensity to consume, t is the marginal tax rate, m is the marginal propensity to import, -d is the interest sensitivity of investment, -n is the interest sensitivity of net exports.

Case 2 (interest sensitive components of aggregate demand like housing and business fixed investment are really sensitive): The interest sensitivity of investment is so high that as soon as output rises, interest rates rise by epsilon, driving down investment so that income returns to original levels. The same logic works if the interest rate sensitivity of net exports is infinite (higher interest rates induce a stronger dollar which increases imports and decreases exports).


Interestingly, many critiques of the effectiveness of monetary policy (low interest sensitivity of investment) imply effective fiscal policy.

These cases are the ones in which fiscal policy is completely ineffective. Many of the arguments against a fiscal stimulus being effective seem to focus on the marginal propensity to consume being small; holding all else constant, this would indeed mean a smaller multiplier. But fiscal policy would still be able to increase output. The layout of the model and the analysis of non-pathological cases is here [pdf].

Case 3 (households and firms like holding a lot of their wealth in the form of cash, holding interest rates constant): The wealth sensitivity of money demand is very high, so when a budget deficit is run, wealth (money plus government bonds) held by the private sector rises, pushing up the equilibrium interest rate.


Where j is the wealth sensitivity of money demand (i.e., when wealth rises by $1 billion, money demand rises by $j billion); and α-hat is (1-b(1-t)+m+(d+n)k/h) -1

This is “portfolio crowding out”, that is where government borrowing — associated with deficit spending — in the credit markets raises interest rates on government bonds (decreases the price of government bonds).

However, a large j doesn’t seem plausible to me, except perhaps in times when risk aversion is extremely high. That applies to the current moment, but with risk spreads declining, I think that concern will be less relevant over time.

What seems more plausible is that μ increases exogenously — but that argument would carry even in the absence of a fiscal expansion. So one might as well undertake the fiscal stimulus. The derivation of the model is here [pdf].

Case 4 (no need to do anything — we’re already doing as well as we can): Output is at full employment levels. This can be true if we are in a Classical world (the aggregate supply curve is like one big production function, and is vertical in price-income space), in the New Classical/ real business cycle world, or in the Lucas supply curve (approximately a Classical model with uncertainty and rational expectations) world (see here [pdf]). But, if one is working in the neo-Classical synthesis, this would be shown as the following:


So, if the aggregate demand curve intersects the vertical portion of the aggregate supply curve, then an increase in aggregate demand only increases the price level. Of course, what an AD curve intersecting the AS curve on the vertical portion means is that there are no underutilized resources in the economy. That hardly seems a plausible interpretation of the current situation.

I would say that a “backwards-L” shaped aggregate supply curve is a little implausible in the medium run (and is not standard in most macro textbooks). Hence, for most parameter configurations, fiscal policy will have some effectiveness, as long as prices are somewhat sticky.

Case 5 (government debts will have to be paid off in its entirety the future): When budget constraints hold with certainty intertemporally, and there is no way to default even partially on government debt (say via unexpected inflation), then increases in government debt due to tax cuts (for instance) induce no change in curent consumption because households fully internalize the present value of the future tax liability. This “neo-Ricardian equivalence” (not that Ricardo actually believed in it) makes some sense, although to my knowledge no empirical studies support it holding in full.

Now, there are plenty of other, more reasonable, critiques that pertain to the degree of efficacy (how big the multiplier is, whether the spending will occur in time, etc.):

  • Timing (I): That is the argument (not yet proved) that much of the spending in this bill will occur not within the next 18 months [0]. This argument seems to be based on this CBO computer run of a component of an earlier proposal, not the current plan (see Dean Baker). Hence, one needs to await an assessment of the current proposal before one can jump in. Second, even if some of the spending is going to occur outside of the 18 month time frame, well, that still might be relevant; see this post.
  • Timing (II): Spending will occur in the future, even after the long downturn (here is a passionate statement of that argument ). Although, if one believes in rational expectations, then higher aggregate demand in the future will induce higher spending today. I’m skeptical of the strenght of this intertemporal linkage, and agree it would be better if the spending could occur sooner rather than later.
  • Small marginal propensity to consume (the b parameter in the discussion above). This is a hard one to believe for a country with 70% of GDP accounted for by consumption, but it’s true that a case can be made for a smaller MPC going forward. Nonetheless, that seems to argue for a bigger stimulus, not none at all. And the relevant MPC is not a given; it depends upon where the spending or tax cuts are directed at. That’s why I’ve argued for tax cuts to the poorest and most liquidity constrained, and spending on goods and services (rather than nontargeted tax cuts and transfers to high income deciles) [1].

That last point drives my skepticism about demands for a much greater role for tax cuts as opposed to spending, as suggested by some (e.g., [2]).

There are of course a whole host of ideologically based arguments against increasing spending and/or cutting taxes further. I leave those points for others to debate.

Originally published at Econbrowser and reproduced here with the author’s permission.

2 Responses to "Five Reasons Why Fiscal Policy Might Be Completely Ineffective: A Textbook Exposition"

  1. faberm   January 30, 2009 at 7:14 am

    Mr. Chinn’s article looks very important, but it is not understandable or applicable to the average reader. Mr. Chinn, should rewrite the article so that it will be relevant (as are other RGE articles) to readers who are looking for information on what is happening in the economy and how it might affect their lives. I appreciate the academic nature of the article, and it seems very important, I just don’t really understand the bottom line of it and how it will affect me. Just my humble thoughts, faberm

  2. Guest   January 30, 2009 at 12:10 pm

    The hopeful innocence of classical equilibrium economics encourages me to add my criticism of this whole approach: where are the driving forces of manipulation? Where is that variable representing the Fed seeking banking hegemony through bailouts destructive to the general economy, private sectors seeking nonrestorative handouts (eg. autos), lenders seeking exogenous (i.e. government) relief from previously exploitive and now nonperforming loans, threatened credit agencies withholding credit for temporary reasons of self interest, and short-sighted populism leading to protectionism? These nonequilibrium forces are not contained in equilibrium economics and, as such, I can only looking on the scenarios presented here as marginally useful at best.