Guest blog: The Integral Reviews: Paper 3 – Hall (2009)

Guest blog – The Integral Reviews: Paper 3 – Hall (2009)
by “Integral”

Reviewed: Robert Hall (2009), “By How Much Does GDP Rise If the Government Buys More Output?” NBER WP 15496

Executive summary

The average government purchases multiplier is about 0.5, taking into account empirical and structural evidence. The only way to get “large” multipliers of 1.6 is to assume a large degree of non-optimizing behavior, an inflexible wage rate, at the zero lower bound on nominal interest rates, and assuming monetary policy is completely ineffective at influencing aggregate demand but the fiscal authority retains that influence.

The key ingredients to generating a large output multiplier are sticky wages/prices, a highly countercyclical markup ratio, and “passive” monetary policy which does not counteract the fiscal expansion.

The assumptions that underlie “the effectiveness of monetary policy” (sticky prices and a countercyclical markup) also drive “the effectiveness of fiscal policy.” The two are similar in that respect.

Summary

Hall provides a convenient overview of the state of economic knowledge about the government purchases multiplier. He does this in four steps: simple regression evidence, VAR evidence, structural evidence from RBC models, and structural evidence from various sticky-price/sticky-wage models.

Empirical evidence begins with the simple OLS regression framework. Hall obtains the output multiplier by regressing the change in military expenditures (a proxy for the exogenous portion of government spending) on the change in output. He finds multipliers significantly larger than zero but less than unity, mostly in the neighborhood of one-half. This estimate of the “average multiplier” is confounded by two problems: (1) the implied multiplier be taken as a lower bound rather than an unbiased estimate due to omitted variable bias, and (2) the estimates are driven entirely by observations during WWII and the Korean War.

The VAR approach produces a range of estimates. Hall surveys five prior studies and finds that the government purchases multiplier is non-negative upon impact across all studies and consistently less than unity, but there is much variation in the exact point estimate. The VAR approach typically suffers the same omitted variable bias as OLS.

Hall then turns to a review of the structural evidence. He first shows the standard RBC result that if wages and prices are flexible, the output multiplier is essentially zero or even negative. While a useful benchmark this is not particularly useful for applied work.

Adding wage frictions forces laborers to operate off of the labor supply curve, so output could plausibly expand from an increase in government demand. Hall indeed finds that the multiplier is higher in small-scale NK models and depends on consumer behavior. With consumers pinned down by the permanent-income/life-cycle model, multipliers tend to range around 0.7. If consumers are rule-of-thumb or iiquidity constrained, one finally finds multipliers above unity, in the neighborhood of 1.7, in the presence of the zero lower bound on nominal interest rates.

Review

The empirical evidence is plagued by persistent endogeniety and omitted-variable bias, which Hall frankly acknowledges. Identification is extraordinarily difficult in macroeconomics; as a practical matter it is impossible to untangle all of the interrelated shocks the economy experiences each year.

On the theory side, Scott Sumner would consider this entire exercise a waste of time: the Fed steers the nominal economy and acts to offset nominal shocks; government shocks are a nominal shock, so the Fed will act so as to ensure that the government expenditures multiplier is zero, plus or minus some errors in the timing of fiscal and monetary policy.

Is this a good description of the world? On average over the postwar period, a $1 exogenous change in government spending has led to a $0.50 increase in output; excluding the WWII and Korean War data drive this number down significantly. As a first-order approximation the fiscal multiplier is likely zero on average. But we don’t care about the average, we care about the marginal multiplier, at the zero bound. In that scenario, multipliers are on average higher but still below unity. A crucial open question is to what degree the monetary authority “loses control” of nominal aggregates at the zero lower bound, and to what degree fiscal policy is impacted if the monetary authority is “helpless”. (If we are in a situation where the Fed cannot move nominal aggregates, why wouldn’t Congress be similarly constrained?)

Hall’s paper does not explicitly discuss monetary policy. However, adding a monetary authority to his models would only reduce the already-low multipliers that Hall uncovers. His point, that one cannot plausibly obtain multipliers in excess of unity in a modern macro model, is already well-established even without explicitly accounting for the central bank.

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Tyler Cowen on the gold standard

Here is Tyler Cowen on the gold standard:

“The most fundamental argument against a gold standard is that when the relative price of gold is go up, that creates deflationary pressures on the general price level, thereby harming output and employment. There is also the potential for radically high inflation through gold, though today that seems like less a problem than it was in the seventeenth century.

Why put your economy at the mercy of these essentially random forces? I believe the 19th century was a relatively good time to have had a gold standard, but the last twenty years, with their rising commodity prices, would have been an especially bad time. When it comes to the next twenty years, who knows?

Whether or not there is “enough gold,” and there always will be at some price, the transition to a gold standard still involves the likelihood of major price level shocks, if only because the transition itself involves a repricing of gold. A gold standard, by the way, is still compatible with plenty of state intervention.”

I fully agree – I think it would be an extremely bad idea to introduce a gold standard today. That does not mean that the gold standard does not have some merits. It has – the gold standard will for example significantly reduce discretion in monetary policy and I surely prefer rules to discretion in monetary policy. Furthermore, I think that exchange rate based monetary policy also has some merits as it can “circumvent” the financial sector. Monetary policy is not conducted via a credit channel, but via a exchange rate channel – that makes a lot of sense in a situation will a financial crisis.

However, why gold? Why not silver? Or Uranium? Or rather a basket of commodities. Robert Hall has suggested a method that I fundamentally think has a lot of merit – the ANCAP standard, which is a basket of Ammonium Nitrate, Copper, Aluminum and Plywood. Why these commodities? Because as Robert Hall shows they have been relatively highly correlated with the general cost of living. I am not sure that these commodities are the best for a basket – I in fact think it would make more sense to use a even broader basket like the so-called CRB index, but that is not important – the important thing is that the best commodity standard is not one with one commodity (like gold), but rather a number of commodities so to reduce the volatility of the basket.

Furthermore, it makes very little sense to me to keep the exchange rate completely fixed against the the commodity basket. As I have advocated in a number of earlier posts I think a commodity-exchange rates based NGDP targeting regime could make sense for small open economies – and maybe even for large economies. Anyway, the important thing is that we can learn quite a bit from discussing exchange rate and commodity based monetary standards. Therefore, I think the Market Monetarists should engage gold standard proponents in in 2012. We might have more in common than we think.

Now I better stop blogging for this year – the guests will be here in a second and my wife don’t think it is polite to write about monetary theory while we have guests;-)

Happy new year everybody!

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