Tuesday, December 30, 2008

Liquidity trap and optimal fiscal policy

Following New Keynesian Economics models, Krugman sketches out a model where he shows the optimal fiscal policy (increasing government expenditure up to the point where full employment is maintained) when the economy is in a liquidity trap.

…when the economy is in a liquidity trap government spending should expand up to the point at which full employment is restored. That’s not a guess or a statement of personal preferences, it’s a result.

The basic intuition behind this result is that when the economy is in a liquidity trap, the social marginal cost of government spending is low, because there isn’t enough private demand to fully employ the economy’s resources. This means that we would normally expect more government spending to raise welfare, right up to the point that full employment (a concept that needs a bit of explanation here) is restored. At that point the marginal cost of government spending jumps up, because it’s diverting resources from private spending.

What I’ve illustrated here is the marginal cost and benefit of government purchases of public goods in and near a liquidity trap. The marginal benefit is presumably a downward-sloping
curve. If G is low, so that monetary policy cannot achieve full employment, the marginal cost of an additional unit of G is low, because the additional government purchases don’t crowd out
private spending. Once G is high enough to bring full employment, however, any further rise in government purchases will be offset by a rise in the interest rate, so that extra G does come at the expense of C, implying a jump in the marginal cost.

As the figure suggests, there should be a fairly wide range of situations in which the optimal level of G is precisely the level at which the marginal cost jumps – that is, the optimal fiscal
expansion is one that brings the economy right to full employment.

…The bottom line here is that while we usually think of Keynesianism as the preserve of ad hoc models, in this case doing it “right” – using a macromodel with maximizing agents and a proper concern for intertemporal constraints – actually suggests a very strong case for big government spending in the face of a liquidity trap. When the economy is depressed and monetary policy can’t set it right, the true opportunity cost of government spending is low. So let’s get those projects going.