What Fiscal Policy is Effective at Zero Interest Rates? Gauti B. - PowerPoint PPT Presentation

What Fiscal Policy is Effective at Zero Interest Rates? Gauti B. Eggertsson, NY Fed Talk at Atlanta Fed, Jan 2010 Talk at Atlanta Fed, Jan 2010

Motivation: Fiscal Expansion Today Motivation: Fiscal Expansion Today • The current fiscal expansion the greatest in The current fiscal expansion the greatest in peace time since 1933. • Estimated deficits of gigantic proportions • Estimated deficits of gigantic proportions • Basic question: What’s the effect of cutting taxes and increasing spending in a standard d i i di i d d New Keynesian model at zero interest rates.

Starting point: Some discussion on labor and capital tax cuts l b d l • Labor tax cuts: – Bils and Klenow (2008): ( ) • Payroll tax cuts stimulates employment directly by reducing tax penalties • “Works directly on demand” Works directly on demand • “Works under all business cycle models” – Hall & Woodward, Becker, and Mankiw raise similar arguments. – Edward Prescott, Council of Foreign Relations: , g “Don’t subsidize inefficiency. Cut tax rates to get people to work more. This financial stuff is much ado about nothing.“ • Capital tax cuts – Barro (2009) ( ) “On the tax side, we should avoid programs that throw money at people and emphasize instead reductions in marginal income ‐ tax rates ‐‐ especially where these rates are already high and fall on capital p y y g p income.” ‐‐ Feldstein (2009)

This paper Standard “New Keynesian” model • • Fiscal policy under the “current circumstance”. – Intertemporal shocks so that the nominal interest rate is zero (origin: Intertemporal shocks so that the nominal interest rate is zero (origin: financial sector) Consider temporary variations in taxes and spending in response to • this shock. Findings: • – Cutting labor taxes and/or capital taxes contractionary. – Cutting sales taxes, investment tax credit or increasing government spending expansionary spending expansionary . • Special to zero interest rates: – Cutting labor taxes “normally” expansionary – Cutting capital taxes “normally” has little effect Cutting capital taxes normally has little effect – Increasing government spending (cutting sales taxes) usually less than one. Multiplier more than 6 times larger at zero (goes from 0.32 to 2.27). – Implication: Can’t use empirical work at positive interest rate. Theory li i ’ i i l k i i i h better benchmark.

Basic point Basic point • At zero interest rates “insufficient demand” is the problem • Policy (either tax cuts or spending increases) should aim at: – INCREASING DEMAND – get more spending going. – Increasing supply is counterproductive • Don’t want to produce more when the problem is that p p there are not enough buyers! • Paradox of thrift (old): Giving people the incentive to save more (cutting capital taxes) reduces spending. [in more (cutting capital taxes) reduces spending. [in equilibrium this reduces aggregate savings ] • Paradox of toil (new): Giving people the incentive to work more counterproductive. More supply of labor ‐ > lower more counterproductive. More supply of labor lower wages ‐ > deflationary pressures � higher real rates. [in equilibrium this reduces aggregate work ] • Sidepoint: What did the “Obamaplan” do? Increase output Sidepoint: What did the Obamaplan do? Increase output by 3.6 percent.

Plan Plan 1. Basic model, key results – i. contractionary labor income tax cuts ii. contractionary capital tax cuts 2 Other demand and supply policies 2. Other demand and supply policies i. a. expansionary government spending b. irrelevant government spending ii. sales tax cuts iii. Cutting taxes on profits and investment tax credit iv. monetary policy iv. monetary policy 3. Quantitative evaluations 4. Conclusions

The Model shock Households Utility ∞ ⎡ ⎤ ∑ ∫ 1 β − + + − ξ T t S N max E u ( C G ) g ( G ) v ( L ( j )) dj ⎢ ⎥ ⎣ ⎦ t T T T T T 0 = T t Fiscal policy instruments s.t. budget constraint ∫ ∫ 1 = − τ + + − τ Π A P B ( ( 1 )( )( 1 i ) ) B ( ( 1 ) ) ( ( i ) ) di − − − t t t t 1 1 t t 1 1 t t 1 1 t t T T 0 ∫ 1 + − τ − + τ − w s ( 1 ) w ( j ) L ( j ) dj ( 1 ) P C T t T T t t t t 0 Consumption and price indices θ ⎡ ⎤ 1 θ − 1 θ − 1 ⎡ ⎡ ⎤ ⎤ ∫ ∫ 1 ∫ ∫ 1 − θ − θ ≡ ≡ ≡ ≡ 1 θ θ 1 ⎢ ⎢ ⎥ ⎥ C C c c ( ( i i ) ) di di , P P p p ( ( i i ) ) di di ⎢ ⎢ ⎥ ⎥ ⎣ ⎦ t t t t ⎣ 0 ⎦ 0

The Model Sticky Prices Monapolistically competetive firms and linear production function p ( i ) = − θ = t y ( i ) Y ( ) y ( i ) L ( i ) t t t t P t t Calvo prices. Fraction (1 ‐α ) of firms set new prices in each period (exclusive of sales tax). ∞ * * p p ∑ ∑ αβ αβ − − τ τ − θ − − θ = = T t P * t t max max E E { { ( ( ) ) Q Q ( ( 1 1 )[ )[ p p ( ( ) ) Y Y w w ( ( j j )( )( ) ) Y Y ] ] } } 0 0 * t t , T T t T T T p P P t = t T T T Resource constraint = + + + + S N Y Y C C G G G G t t t t

+ τ s P ( 1 ) ξ = β ξ − τ + A t t u E u ( 1 )( 1 i ) + + + τ + c , , t t t c , , t 1 t 1 t t s s P P ( ( 1 1 ) ) + + t 1 t 1 − τ w v 1 W ( j ) = l , t t t 1 − τ s P u t t c , t θ ∞ * * p p W ( j ) ∑ ∑ αβ β − − τ − θ − − = T t P 1 t t T { { ( ( ) ) Q Q ( ( 1 )( )( ) ) Y [ [ ] ] } } 0 θ − t t , T T T T T T P P 1 P = t T T T T 1 − + θ − θ = = − α α + α α − θ θ * 1 1 1 1 P P [( [( 1 1 )( )( p p ) ) P P 1 ] ] − t t t = + + ≥ S N Y C G G i 0 t t t t t t − τ τ τ τ − ξ * w A s p S N { Y , C , p , P } { i , , , , , G , G } { } t t t t t t t t t t t t

Summarizing the model Summarizing the model shock = − σ − π − ξ ˆ ˆ e Y E Y ( i E r ( )) + + t t t 1 t t t 1 t AD + + − − σ σ τ τ − τ τ + + σ σ τ τ ˆ ˆ N N s s A ˆ ˆ ˆ E E ( ( G G G G ) ) E E ( ( ) ) + + t t t 1 t t t 1 t π = κ + β π + κψ τ + τ − κψσ − ˆ ˆ s w 1 N ˆ ˆ Y E [ ] G AS + t t t t 1 t t t ≥ i 0 ZB t − ≡ β + ξ − ξ ˆ ˆ e 1 r log E + t t t t 1

Baseline policy Baseline policy = = + + φ π φ π π + + φ φ ˆ e i i max( max( 0 0 , r r Y Y ) ) t t t y t = τ = τ = τ = τ = ˆ s s w w p p A A ˆ ˆ ˆ ˆ ˆ ˆ ˆ ˆ G 0 and 0 t t t t t Emphasis here: Policy on the margin i e “multipliers” Policy on the margin , i.e. multipliers Well defined “benchmark” and study perturbations from this benchmark Will not talk about optimal policy e.g. Ramsey or Markov Perfect allocations .

Effect of labor income tax cuts: Standard when no shocks Experiment: Consider a temporary tax cuts that are Experiment: Consider a temporary tax cuts that are reversed with probability 1 ‐μ π = ? ? L π = = ˆ Y 0 = ˆ H H Y ? L τ < τ = w w ˆ ˆ 0 0 H L − μ 1 = t = e t 0 T

φ − ρ = − σ π π ˆ = − μ − σ − π ˆ ˆ Y AD Y ( 1 ) Y ( i ) − ρ ρ + σφ φ L L L L L L 1 y y π = κ + κψ τ + − μ βπ ˆ w ˆ AS Y ( 1 ) L L L L AD AS π L π ˆ Y L

Under regular circumstances Under regular circumstances • “Standard” intuition applies • Undergraduate textbooks work just as well as graduate ones • Will now talk about the peculiar circumstances that arise when interest rate zero (paradox of (p toil and thrift)

The source of the contraction (Great Depression, crisis of 2008) (G t D i i i f 2008) Structural Shocks (need this to explain a simultaneous fall in interest rates prices and output in this framework). e ξ r 3% H H − μ 1 e ξ r ‐ 4% L L = t = e e t t 0 0 t T T 1 − − = = β r e r 1 H Preference shocks: Reduced form for – ˆ < = + μ ξ anything that means that interest e r r 0 L L rate needs to decline to clear the market (e.g. banking problems, Curdia and Eggertsson (2009)) Curdia and Eggertsson (2009)) – Everybody want to spend less today relative to tomorrow.

Solution: Solution: Boils down to only two equations! In two unknowns! = = μ μ + + σμπ σμπ + + σ σ ˆ ˆ e Y = = − σ σ − π π − ˆ ˆ Y Y Y Y r r e Y E E Y Y ( ( i i E E r r ) ) + + t < L L L L e t t t 1 t t t 1 t T π = κ + μβπ ˆ π = κ + β π 1 + κϕ τ ˆ w Y ˆ Y E + L t t L t t L t Purely forward looking < e For t T For t ≥ e T = − μ ⋅ + + μ ⋅ ˆ ˆ = π = ˆ E E Y Y ( ( 1 1 ) ) 0 0 Y Y Y Y 0 0 + t t 1 L H H π = − μ ⋅ + μ ⋅ π E ( 1 ) 0 + t t 1 L = and i 0 t