The Brass Tack

Let's get down to it.

Why stimulus could have a large multiplier, and why it probably doesn’t.

Posted by srconstantin on July 13, 2009

Brad DeLong points to an interesting new paper.

Recall the flow -of-funds balance equation:

S(Y, 0-π) = D + I(0-π)

Savings S as an increasing function of income Y and of the real interest rate, which is the nominal interest rate 0 (we are at the lower bound) minus the inflation rate π, is equal to the government deficit D plus investment I which is a decreasing function of the real interest rate, which is the nominal interest rate 0 minus the inflation rate π.

An increase in the deficit thus (a) directly increases saving S necessary to finance the deficit which requires a direct increase in Y. But this direct increase in Y then increases inflation π–there is less deflation. And less deflation means both less savings and more investment. So the direct effect increase in Y does not generate enough savings to close the gap in the flow-of-funds market: savings must increase by more–which requires that Y increase by even more. The government deficit thus genuinely “primes the pump” and the multiplier is very large.

This channel is, I think, the channel pointed to by those who think that the New Deal had an enormous impact, as Roosevelt’s deficits in combination with the increase in price rigidity produced by the NIRA and the breaking of deflationary expectations created by the abandonment of the gold standard diminished desired S.

But I don’t think we have big expectations of deflation right now. And I don’t think fiscal policy moves right now are having a great deal of effect in reducing expected deflation. So I don’t think the interaction of output gaps and deflation is playing a big role in boosting the multiplier right now…

He’s right: the gap between TIPS and Treasury bills has grown, signaling that deflation fears are not very high:
TIPS typically yield less than Treasuries because their principal payments rise at the rate of inflation. A shrinking yield gap indicates investors expect inflation to slow.


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