Answer to Question #101530 in Macroeconomics for Jorge Ferreira

Question

Sketch how in the pure neoclassical model the fiscal multiplier is smaller than one and which is the intution for this result? The fiscal multiplier can be negative? Which implications of a fiscal multiplier negative as well as from a multiplier that is positive and below 1?

Answer 1

Of key importance for assessing the effectiveness of stabilization policies is the calculation of fiscal multipliers. If their value is less than unity (or less than zero, as follows from the hypothesis of non-Keynesian effects), the appropriateness of fiscal stimulus can be called into question.

When the value of the multipliers exceeds unity, this indicates the great potential of expansionary fiscal policy.

The emergence of a new classic and the theory of real business cycles, and then the emergence of a new neoclassical synthesis marked a turn in understanding the tasks of the stabilization policy of the state. The palm turned to monetary policy, and stimulating fiscal policy began to be perceived as a secondary, fallback option in the event of unforeseen situations. In neoclassical models, in the absence of nominal stiffness and under conditions of a fixed stock of capital and a negative slope of the demand function for labor, an increase in government spending leads to an increase in output and employment, which causes a decrease in real wages and, consequently, the level of consumption.Thus, in most neoclassical models, the multiplier of government spending relative to total consumption is negative, and relative to output - close to positive, but close to zero.

In general, the final effect of fiscal stimulus on the economy in the neoclassical version is less significant compared to the Keynesian version. Accordingly, the value of the multiplier is also supposed to be much smaller, although neoclassicists recognize the possibility of its increase in a recession situation.. At the same time, the final impact on output and aggregate demand can be both positive and negative, but in any case, multiplier processes based on a positive reaction from the point of view of private consumption are blocked. The new synthesis models are built on a neoclassical platform, so there is no long-term fiscal policy potential in them, although in the short term the possibilities of discretionary fiscal stimulation are recognized - subject to severe restrictions on the use of monetary instruments and built-in fiscal stabilizers.In this regard, the size of the multiplier effects in such models depends on the prerequisites for the reaction of monetary policy to changes in budget parameters.