Fiscal policy multipliers are central to Keynesian macroeconomics. In this paper I explore a possible microeconomic foundation for one fundamental theory of income determination, the ‘Keynesian cross’. My model deviates from a Walrasian equilibrium model only by the assumption of imperfect competition in the goods market. I show that textbook fiscal policy multipliers arise as a limiting case.
Under imperfect competition, firms are always eager to sell an additional unit of output, since price exceeds marginal cost. This profit margin creates the potential for the multiplier. An expansionary change in fiscal policy increases aggregate expenditure, which increases profits, which in turn increases expenditure, and so on.
The theme that imperfect competition may be crucial to macroeconomic issues is increasingly prevalent. See, for example, the work of Weitzman (1982) Hart (1982) Solow (1984), Blanchard and Kiyotaki (1985), and Startz (1986). The purpose of the model presented here is partly pedagogical. I therefore do not hesitate making strong (yet not implausible) assumptions about the economic structure: Cobb-Douglas utility, constant marginal cost, and constant mark-up pricing. There is no reason to suppose, however, that the sorts of effects highlighted here are specific to these assumptions.
While the model is in some ways surprisingly similar to the standard Keynesian model, in other ways it differs greatly. In particular, it incorporates both an equilibrium labor market and a static environment. These features are chosen for simplicity rather than realism. The goal is not to provide a complete reformulation of Keynesian economics, but only to illustrate what sort of Keynesian results one can obtain with a small movement away from Walrasian equilibrium in the direction. of imperfect competition.
Both increases in government purchases and reductions in taxes increase welfare. In standard analysis, increases in G or reductions in T are financed by future generations. Here, these changes are financed by reductions in government workers W. In neither case is it surprising that the welfare of current individuals increases.
The model examined here is surprisingly similar to both Walrasian models of general equilibrium and Keynesian models of income determination. It deviates from a standard general equilibrium model only by the assumption of imperfect competition in the goods market. As competition in the goods market becomes less perfect, the fiscal policy multipliers approach the values implied by the Keynesian cross.
The model could be usefully extended in several directions. First, the labor market might be made less classical. One could posit imperfect competition among workers, for example. Some of the rents generated by expansionary fiscal policy would therefore accrue as labor income. The multiplier would thus work through both labor income and firm profits.
Second, the model could be made intertemporal. The impact of debt-financed fiscal policy obviously cannot be studied in a static model. That saving and investment play an important role in standard Keynesian analysis also suggests extending this model to a dynamic setting.
My description of this paper as one my favorites is not false flattery; I used to teach this paper regularly to my PhD students (syllabus here). A working paper version is available here. The paper was published in Economics Letters (1988), reprinted in New Keynesian Economics, and was written by Greg Mankiw.
Originally published at Econbrowser and reproduced here with the author’s permission.