13.4 Calibrating Macroeconomic Stabilization Policies: Lags, Multipliers, and Crowding Out

As we discussed above, both monetary and fiscal countercyclical stabilization policies are subject to lags. Although monetary policy can be implemented immediately once the policy is formulated, the long and variable impact lag makes the timing of policy implementation tricky. Because it takes six months or more before monetary policy has its major impact on the economy, the Fed Chair and Board of Governors must be very forward-looking when implementing policy changes. Fed economists pay careful attention to leading economic indicatorsSources of information such as the Consumer Confidence Index (CCI), initial jobless claims, durable good orders, and building permits—which are used to predict future changes in GDP and the price level. —such as the Consumer Confidence Index (CCI), initial jobless claims, durable good orders, and building permits—which are used to predict future changes in GDP and the price level. If the Fed expects inflationary pressures to increase six months or a year in the future, it must decide when to implement contractionary monetary policy (higher interest rates) and how contractionary the policy should be. As William McChesney Martin, Chairman of the Fed during the Eisenhower Administration, said in 1955, the Fed “is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”1

If the Fed waits too long to implement contractionary monetary policy, inflationary expectations of workers, employers, and consumers may convert demand-pull inflation into cost-push inflation (“a wage-price spiral”) that is difficult to reduce. If the Fed acts too quickly to implement contractionary policy, it can convert an expansion into an economic downturn or even a recession. If Fed economists believe that the economy is headed for a recession six months or a year in the future, the Fed must decide the timing and magnitude of expansionary monetary policy to keep economic activity at an even pace. If it waits too long, the economy may experience a recession. If it acts too quickly, it can create inflation. Because monetary policy impact lags are variable (six months to two years), it has been suggested that the Fed Chair needs to be a “prophet” to keep monetary policy countercyclical.

Fiscal policy has an almost immediate impact on economic activity. However, as you have learned, it can have a very long implementation lag. Historically, it has been politically easier to implement expansionary fiscal policy (increased government expenditures, reduced taxes, and increased transfer payments) than contractionary fiscal policy (reduced government purchases, increased taxes, and reduced transfer payments). Hence, fiscal policy has had an “inflationary bias.” But political differences about the exact composition of tax, spending, and transfer payment policy sometimes slow or stop the implementation of expansionary fiscal policy, and often slow or stop the implementation of contractionary fiscal policy. In some cases, by the time the policy is implemented, it is no longer needed, or its magnitude is wrong for the economic circumstances. Fortunately, as was mentioned earlier, in serious economic emergencies, partisan politics is usually set aside, and fiscal policy is implemented quickly.

The size of the effect of short-run stabilization policy on equilibrium GDP and the price level depends on the size of the shift in the aggregate-demand curve and on the slope of the short-run aggregate-supply curve. For a given shift in the aggregate-demand curve, the flatter the slope of the aggregate-supply curve, the greater will be the change in GDP and the smaller will be the change in the price level. Figure 13.1 illustrates this concept.

Starting at short-run equilibrium E₀, where aggregate-demand curve AD₀ and short-run aggregate-supply curve AS₀ intersect, if aggregate demand increases to AD₁, the new equilibrium is at E₁. GDP increases from Y₀ to Y₁, and the price level increases from P₀ to P₁. Alternatively, suppose the aggregate-supply curve is steeper, as shown by AS₁. The given increase in aggregate demand results in a new equilibrium at E₂. GDP increases from Y₀ to Y₂, and the price level increases from P₀ to P₂. If the aggregate-supply curve is flatter, as shown by AS₂, the given increase in aggregate demand results in a new equilibrium at E₃. GDP increases from Y₀ to Y₃, and the price level increases from P₀ to P₃. If the aggregate-supply curve is vertical, as it is in the long run, the only impact of a change in aggregate demand is a change in the price level.

The multiplierThe size of the shift in the aggregate-demand curve for each $1 change in fiscal policy. is the size of the shift in the aggregate-demand curve (change in total spending on goods and services at each price level) for each $1 change in fiscal policy (government purchases, taxes, or transfer payments). The multiplier effect on spending in the economy is like the money-multiplier effect you studied in Chapter 9, where an increase in reserves in the banking system results in a multiplied increase in the money supply.

Suppose the government spends an additional $10 billion on new highway construction. The immediate effect is an increase in aggregate demand of $10 billion, since government purchases are a component of aggregate demand. The construction companies that receive the $10 billion hire more employees, buy more equipment and materials, and experience higher profits. Managers and employees of the construction companies and their suppliers have $10 billion additional income from earnings and profits. With more income, the managers and workers will purchase more consumer goods and services, and aggregate demand will increase even more. The managers and employees of the firms producing the consumer goods and services will also experience increased income, and their own consumption expenditures will increase. The process spreads through the economy, with each new round of consumption spending further increasing aggregate demand.

It is possible to calculate the size of the spending multiplier that happens when new government purchases induce additional consumption spending in the economy. The size of the multiplier depends on the fraction of each additional dollar of income earned by households that will be spent on consumption rather than saved. That fraction is called the marginal propensity to consume (MPC)The fraction of each additional dollar of income earned by households that will be spent on consumption rather than saved.. Suppose that households spend $0.80 of each additional dollar of income and save $0.20. In that case, the MPC is 4/5. The multiplier effect of a change in government purchases can be shown step-by-step. Using the previous example, the first step is an increase in government purchases of $10 billion. The second step is the increase in consumption from the $10 billion additional household income, which is MPC × $10 billion. The third step is the increase in consumption from the additional MPC × $10 billion of household income, which is MPC × MPC × $10 billion, or MPC² × $10 billion. The third increase would be MPC³ × $10 billion, and so on. Adding all these steps of additional household income leading to increased consumption, we have the following:

$\text{Total change in demand}=(1+\text{MPC}+{\text{MPC}}^2+{\text{MPC}}^3+\dots )\times \$10\text{ billion}$

where … denotes an infinite number of similar terms.

From the above equation, we can write the multiplier as

$\text{Multiplier}=1+\text{MPC}+{\text{MPC}}^2+{\text{MPC}}^3+\dots$

You may recall from mathematics that the multiplier is an infinite geometric progression that has a simplified solution:

$\text{Multiplier}=1+\text{MPC}+{\text{MPC}}^2+{\text{MPC}}^3+\dots =\frac{1}{(1-\text{MPC})},\text{for MPC}<1.$

In our example, MPC = 4/5. Therefore, the multiplier is 1/(1 − 4/5) = 5, and the increased government purchases of $10 billion would induce an additional $40 billion of consumption, for a total spending increase of $50 billion. Hence, the aggregate demand curve would shift to the right by $50 billion, as illustrated in Figure 13.2. The original equilibrium is E₀, at the intersection of the aggregate demand curve AD₀ and the aggregate supply curve AS. The $10 billion in additional government purchases shifts the aggregate demand curve to AD₁. Without the multiplier effect, the new equilibrium would be at E₁. The multiplier effect on consumption shifts the aggregate demand curve to AD₂, and the new equilibrium is at E₂.

If the MPC were 3/4 instead of 4/5, the multiplier would be 1/(1 − 3/4) = 4. If the MPC were 9/10, the multiplier would be 10. The larger the MPC, the larger the multiplier. Spending multipliers apply to reductions in government purchases as well. If the government had reduced purchases by $10 billion in our example, the aggregate-demand curve would have shifted to the left by $50 billion.

Other fiscal policies also have multiplier effects. For example, a reduction in income taxes would increase household disposable income and lead to additional consumption expenditures, creating increased income for managers and employees of firms producing the consumer goods. In turn, those managers and employees would increase their own consumption, and so on. A reduction in transfer payments to households would have the opposite multiplier effect, since disposable income would be reduced, leading to reduced consumption expenditures by the households. The reduction in consumption spending would reduce incomes of managers and employees of firms producing consumer products, leading to further reductions in consumption, and so on.

Even though fiscal policy has a multiplied effect on aggregate demand, it also affects the interest rate, as you learned earlier. Expansionary fiscal policy causes interest rates to rise, and contractionary fiscal policy causes interest rates to fall. In our example, the multiplier effect transformed the $10 billion of government purchases into $50 billion of total spending. But the higher interest rates caused by the increased spending would reduce investment, crowding out some of the effect of the expansionary fiscal policy. The net result of crowding outA situation in which increased government spending leads to reductions in private sector spending or investment. is shown in Figure 13.3. In this figure, the increase in aggregate demand predicted by the multiplier is shown as the shift from AD₀ to AD₁ with the equilibrium point moving from E₀ to E₁. The crowding-out effect is shown as the leftward shift of the aggregate demand to AD₂, and the actual equilibrium is at E₂.

Because of crowding out and other causes, the actual fiscal policy multiplier is smaller than the one predicted by the simple equation above. For example, there are “leakages” from income that reduce the amount of additional household income available for purchasing domestically produced goods and services. These leakages include purchases of imported products and taxes that are based on income. The greater the leakages, the smaller the actual multiplier. The multiplier is also affected by perceptions about the economy. During economic expansions, people feel wealthier because of higher values of assets such as stocks and houses. When people feel wealthier, the marginal propensity to consume increases. During economic downturns, the opposite happens. The magnitude of crowding out can also be affected by the relative responsiveness of investment to changes in interest rates. When firms are optimistic about the economy, increases in interest rates will have a smaller impact on investment than if firms are pessimistic.

Crowding out of expansionary fiscal policy can be avoided if the Fed uses accommodating monetary policy. Accommodating monetary policy involves increasing the money supply enough to keep interest rates from rising when expansionary fiscal policy increases the demand for money. In Figure 13.2, accommodating monetary policy would prevent the aggregate demand curve from shifting left to AD₂. The full multiplier effect would be achieved at E₁.

In addition to the timing problem of monetary policy resulting from a variable impact lag, there is also a problem in predicting the size of the impact of a change in monetary policy on aggregate demand. The mechanism of monetary influence in the economy, discussed earlier, has several steps. In the first step, a change in the money supply changes interest rates. The change in interest rates is the result of decisions by households regarding how much of their financial assets they wish to hold as money. The liquid asset, money, has the advantage of being available to finance transactions. Non-liquid assets like bonds, savings accounts, and certificates of deposit (CDs) have the advantage of paying interest. The opportunity cost of holding money as an asset is the market interest rate. If the Fed increases the money supply, households will be holding more money than the amount they need to buy goods and services, so they must decide whether to use the additional money to buy interest-paying assets. If they decide to buy bonds, for example, the price of bonds will increase and the real return to bonds will decrease. The returns to financial assets are interest rates, so to the extent that households use additional money created by the Fed to buy other financial assets, interest rates will fall. If the Fed were to reduce the money supply, households would have less money for transactions than normal, so they would need to decide how many interest-paying assets to sell to have more money for transactions. If they sell assets, asset prices will decrease, and interest rates will increase.

Households’ willingness to convert money into other financial assets, or vice versa, depends on the opportunity cost of holding money—the market interest rate. The higher the market interest rate, the less willing households are to hold additional money created by the Fed and the more willing they are to buy more bonds or other financial assets. The lower the market interest rate, the more willing households are to hold additional money and the less willing they are to buy other financial assets because the opportunity cost of holding the money becomes lower relative to the convenience of holding the liquid asset.

So, for a given amount of increase in the money supply, the market interest rate will decrease more if it is already high than if it is already low. In fact, the nominal market interest rate has a zero lower bound (ZLB)A guideline that no matter how much the Fed increases the money supply, it cannot cause market interest rates to be zero. . No matter how much the Fed increases the money supply, it cannot cause market interest rates to be zero. Before that happened, the opportunity cost of holding money would be so low that the convenience of holding the liquid asset would outweigh the opportunity cost, and when the Fed increased the money supply further, households would simply hold the additional money. For a given amount of decrease in the money supply, the market interest rate will increase more if it is already low than if it is already high. The Fed can avoid the variability of changes in the money supply on interest rates by using an interest rate target rather than a money supply target.

The second source of variability in the size of the impact of monetary policy on aggregate demand is the response of investment to changes in interest rates, the second step in the mechanism of monetary influence in the economy. The most important determinant of business investment is expectation of profitability of investment. This expectation is significantly influenced by firms’ beliefs about future economic conditions. If firms are optimistic about the future, a given decrease in the market interest rate will induce more additional investment than if firms are pessimistic about the future. And a given increase in the market interest rate will cause a smaller reduction in business investment if firms are optimistic about the future than if firms are pessimistic about the future.

In summary, formulating and implementing macroeconomic policy to fit exactly the stabilization needs of the economy is not easy. For fiscal policy, the implementation lag and the variability of the multiplier effect make it difficult to precisely address problems of macroeconomic fluctuations. For monetary policy, the long and variable impact lag as well as the variability of the size of the impact of a given policy on aggregate demand makes it difficult to precisely meet policy goals. Designing effective countercyclical macroeconomic stabilization policy requires forecasting skill and intuition as well as an understanding of the underlying science. Despite the complexity of the process, an understanding of the general impact of macroeconomic stabilization policy on output, employment, interest rates, and the price level will help you as a business manager, worker, consumer, and voter to form reasonable expectations about these macroeconomic magnitudes and to make decisions that will improve your economic future.