How Powerful Are Fiscal Multipliers in Recessions

In policy and academic discussions of recent years, few topics have generated more interest than fiscal multipliers, which measure how much a dollar of increased government spending or reduced taxes raises output. Indeed, the magnitude of fiscal multipliers is at the core of debates about whether governments should try to stimulate their economies during a recession. Bitter disagreement in the United States and elsewhere about the course of fiscal policy during the Great Recession reflects in part how little is known about multipliers and how important this matter is for policy. While previous research studied the effects of fiscal policy on the economy, (1) a key question is how powerful fiscal policy can be in recessions, during which the need to stabilize economic activity is particularly acute. With a quickly shrinking economy in late 2008 and early 2009, existing estimates of the average effect of fiscal stimulus were potentially misleading. For example, old-style Keynesian models emphasized that increased government spending might stimulate output and have little effect on prices in times of slack but could have an inflationary effect with low output response if the economy were close to full employment. More recent theoretical work made a similar prediction in the context of a binding zero lower bound for nominal interest rates, based on the view that a fiscal stimulus would not lead to an increase in interest rates in such a circumstance. (2) While reasonable to expect, cyclical variation in the size of fiscal multipliers has, until recently, been largely unexplored empirically. This glaring gap between what policymakers wanted to know and what earlier work could provide stimulated our interest in exploring state-varying fiscal multipliers. In our initial work on this question we use a "smooth transition vector autoregression" (STVAR) that allows for transition of the economy between regimes characterized by potentially different responses to fiscal shocks. (3) With only a handful of post-World War II recessions, generally short in length, a key advantage of this approach is that it exploits intensive as well as extensive margins of business cycle fluctuations. What matters is not only whether the economy is in a recession but also how deep the recession is. Our approach postulates a function measuring the probability of being in a given regime (recession or expansion) that depends on the state of the economy. The higher the probability of a regime, the more the behavior of the economy will reflect conditions in that regime rather than in the alternative regime. We calibrate this function in such a way that the implied frequency of the economy being in recession matches the frequency of U.S. recessions as determined by the NBER. To measure the state of the economy, we use a coincident business cycle indicator, the deviation of the centered seven-quarter moving average of the real GDP growth rate from the average growth rate. The same paper makes another methodological contribution by using professional forecasts to purge predictable variation from the time series of government spending in constructing measures of unexpected changes in fiscal policy. This adjustment is potentially important because many changes in fiscal variables are predictable and hence potentially anticipated by economic agents. Treating such anticipated changes in fiscal variables as fiscal shocks can attenuate estimates of fiscal multipliers. (4) To construct a long time series of fiscal forecasts at a quarterly frequency, we splice fore casts for fiscal variables using the Survey of Professional Forecasters and "Greenbook" projections made by the staff of the Federal Reserve Board. Our STVAR estimates suggest that multipliers are considerably larger in recessions than in expansions. Although exact magnitudes depend on the horizon and specifics of how multipliers are defined, we conclude that a dollar increase in government spending raises output by about $1. …