Exploring Fiscal Policy at Zero Interest Rates in Intermediate Macroeconomics

Abstract

Since the financial meltdown of 2007, advanced macroeconomic theory has delved more deeply into the question of the appropriate fiscal policy when the nominal interest rate is close to or at zero percent. Such analysis is typically conducted with the aid of New Keynesian Dynamic Stochastic General Equilibrium models. The policy implications are, in some cases, surprising. Multipliers can change by large magnitudes, and the signs of some tax multipliers are reversed. The authors show how these results can be clearly presented to an intermediate undergraduate audience within the standard IS-MP and AD-AS framework of Jones (2011).

Keywords:

• fiscal policy
• monetary policy
• zero interest rate

JEL codes:

• E52
• E58
• E62

Acknowledgments

The authors thank the associate editor of Journal of Economic Education and three anonymous referees for their valuable comments and suggestions that have helped improve the readability of this article.

Notes

1. Not to mention the political constraints to implementing optimal fiscal policy.

2. This is true in models where consumption and leisure are additively separable. See Bilbiie (2009) and Monacelli and Perotti (2010) for details.

3. These are increases as a fraction of GDP in response to a 1-percent change in the policy variable.

4. Many textbooks, including Jones (2011), appeal to adaptive expectations to motivate the persistence of inflation. An alternative is to present an informal but intuitive description of Calvo (1983) pricing as it is consistent with the rational expectations hypothesis.

5. This condition is the direct counterpart to Eggertsson's (2011) stability condition outlined on page 8 of his article and discussed in footnote 20. He models the full dynamics with a two-state Markov process so the stability condition looks more complex, but essentially stable dynamics require that the slope of AD be greater than the slope of AS. This provides a nice opportunity to introduce students to the correspondence principle. A simple cobweb-style graph gets the point across nicely.

6. Eggertsson (2011) made the important point that the increase in government spending must not be a substitute for private consumption spending. Given his assumption of perfect Ricardian equivalence, consumers would simply decrease spending and increase savings by the same amount as the stimulus. One could tell this story to students because the simple AD-AS model holds consumption constant. This is consistent with perfect Ricardian equivalence and a zero intertemporal elasticity of substitution. Thus, the change in a_g should be viewed as new spending on items such as roads or defense.

7. In Eggertsson's (2011) model, there are complementary shifts in AS as workers reallocate time to more labor to make up for the lost consumption associated with higher temporary government spending. We abstract from these issues for the sake of keeping the graph and presentation as simple as possible for our undergraduate audience.