Impact of Fiscal Stimulus on Aggregate Demand

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Because this spending was unanticipated, it was less likely to be subject to mismeasurement due to other economic factors. A similar approach was taken in by Christina Romer and David H. Romer, who used narrative records not only to identify the timing of historical tax changes but also to divide the intended effects of these changes into four categories: stimulating the economy, reducing deficits, inducing higher long-run growth, or other goals.

Ramey, working with multiple co-authors and using a variety of structural predictions of models to analyze macroeconomic policy, has consistently found that multipliers in the United States are small. In contrast, the Romer and Romer approach finds that the multiplier on tax cuts—especially those explicitly meant to stimulate a depressed economy—is quite large.

This is somewhat surprising because theory is very clear that the multiplier on tax cuts should be weakly smaller than on government purchases.

Julian S. Alworth and Giampaolo Arachi

As these more informative, labor-intensive methods gain traction, it is important to note that simple empirics have become much more powerful in the past five years, largely because of policies pursued in response to the Great Recession. It is still true that there is a paucity of relevant data points from advanced economies, but researchers are awash in data compared with 10 years ago. While there may have been some debate about the size of fiscal multipliers before the recession, a broad consensus would have prevented economists from recommending the austerity policies pursued in Europe and the United States since the Great Recession.

The data from these policy actions have demonstrated that austerity has been counterproductive across the globe for the levels of slack seen in the aftermath of the Great Recession. Olivier Blanchard and Daniel Leigh use relatively simple techniques to show that austerity in Europe has consistently resulted in lower GDP growth than was forecasted during the past five years. This is far from the last word on the question of fiscal stimulus.

Data will be revised and improved, and theoretical and empirical techniques will advance, both of which will give us an even clearer picture of what effects fiscal policy can have in a depressed economy. Overall, economic researchers are in much stronger agreement about the usefulness of fiscal policy than they were a decade ago. Ironically, much of the data that have made the empirical work that supports this consensus possible are the result of policymakers going against the existing economic consensus.

Since the onset of the Great Recession, fiscal policy has become a much more widely studied topic in academic circles.

Was the recent slowdown due to a shortage of aggregate demand or supply-side issues?

The broad conclusions of recent work are surprisingly consistent for the field. Fiscal multipliers are larger than we thought, at least in slack economies. Reasonable people can argue that the data do not reject 0.

This research does not indicate that deficits do not matter or that stimulus is always the answer. Instead, the greater consensus around larger fiscal multipliers suggests that fiscal stimulus has fewer risks than we thought and is a very powerful and important tool for boosting short-term economic growth in a way that monetary policy cannot replicate. Turning to austerity before robust economic growth occurs can be self-defeating, depressing economic growth and increasing budget deficits in both the short term and the long term. Considering fiscal policy in a vacuum is a mistake, and it is important to consider the role of the central bank, which has better tools to address too much stimulus than it does to address too much austerity.

More importantly, economic research has developed a new understanding that prolonged, short-run unemployment decreases long-run GDP. The consensus on the costs of inaction has changed dramatically within the field: While many academic researchers thought of the costs of recessions as a rounding error a generation ago, the emerging view is that failing to lift an economy out of recession could permanently reduce its size.

Types of fiscal policy

The takeaway for policymakers is simple. Most importantly, the comforting belief that policymakers can, without causing harm, do nothing while they wait for the economy to rebound is mistaken. The failure to break out of the deep recession and the anemic growth still engulfing Western economies has resulted in significant long-term damage to them. That damage continues to pile up as policymakers ignore the need to get their respective economies back to full employment. Endnotes and citations are available in the PDF and Scribd versions.

Short run vs. Fiscal multiplier This term is used to describe how large an effect on the entire economy we can expect for a given fiscal intervention. Estimating multipliers Developing rigorous estimates of fiscal multipliers is a technical challenge, and state-dependent multipliers are even more difficult to estimate.

Modeling techniques: DSGE and VAR Macroeconomics is very hard to study because there are a relatively small number of data points, so macroeconomic modelers rely on economic theory to extract as much insight from these data as possible. Economics Explore Economics Search Go. Economics Blog. Print page. Some evaluation points 1. Are tax cuts to be preferred to extra government spending? Subscribe to email updates from the tutor2u Economics Join s of fellow Economics teachers and students all getting the tutor2u Economics team's latest resources and support delivered fresh in their inbox every morning.

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Fiscal Stimulus

Curriculum and Training Lead - vocational and technical programmes Ark, London. Shea, John, Shea, J. Fisher, Owen M. Zidar, Europe ," Journal of Public Economics , Elsevier, vol. Valerie A.

Ramey, Nicholas S. Johnson, David S.

Fiscal policy and aggregate demand in the USA before, during, and following the Great Recession

Souleles, Hans-Werner Sinn, Gregory Mankiw, Lutz, Reifschneider, Wilcox, David W, David W. Wilcox, Claudia R. Slemrod, Christina D. Romer, Williams, Alan J. Ravn, Chirinko, Robert S. Jonathan A. Parker, John Y.