Macroeconomic Theory: A Dynamic General Equilibrium Approach
A full set of the Week 9 lecture notes for this module are provided, with in-depth explanations and references from Wickens (2011) and other further reading resources.
We will think about the size of the govt spending multiplier. That is, if the govt increases spending by $1, what
will happen to GDP? If GDP increases by more than $1, then the govt spending multiplier is more than 1. If it
increases by less than $1, then the govt spending multiplier is less than 1.
Ideally, we would want a multiplier greater than 1, but a multiplier less than 1 doesn’t necessarily mean that
govt spending shouldn’t be increased because although it may reduce GDP, it could help achieve other
macroeconomic objectives.
We looked a model of the govt spending multiplier already, where we had a DGE model with 2 agents and a
redistribution policy of transfers going from the high productivity type to the low productivity type. In that
model, we discovered that redistribution policy always has the effect of reducing national income, implying a
govt expenditure multiplier of less than 1.
There are many types of fiscal multipliers including: taxes, spending, deficit and sub-categories of these. In this
lecture, we will be focussing on spending.
-Theory outline
The Keynesian theory states that the govt spending multiplier is greater than 1.
The benchmark DSGE/DGE theory states that typically the govt spending multiplier is less than 1.
The general agreement is that even in a DGE model, the govt spending multiplier can be greater than 1 in 2
cases:
1) When the economy has underutilised resources (e.g., when there is a lot of unemployment or we are in a
deep recession) – this causes the marginal propensity of AD (consumption & and investment) in the
private sector to be higher than usual. As a result, the crowding out of private demand is more muted &
multipliers are larger.
2) When monetary policy (conditions) are accommodative – here, the nominal IR does not increase in
response to fiscal expansion. This is the case when the economy is at the ZLB - The increase in inflation
expectations triggered by an increase in government spending drives the real interest rate down, thereby
stimulating aggregate demand Eggertsson (2011) and Woodford (2011).
DeLong et al. (2012) argues that when the economy is faced with both of these circumstances, the govt
spending multiplier should be, at the minimum, one.
We will look at the multiplier in 4 theories in this lecture:
1) Keynesian theory
2) DGE theory
3) New Keynesian model
4) At the ZLB
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