Christina Romer And Jared Bernstein In The Job Impact Of The

Christina Romer And Jared Bernstein In The Job Impact Of The American

Christina Romer and Jared Bernstein in "The Job Impact of the American Recovery and Reinvestment Plan" calibrated the impact of the proposed expansionary fiscal policy (we know it as an increase in G and/or a lower T) on jobs and GDP growth. They make assumptions about the size of Government spending and tax multipliers. One important assumption is about the level of the federal funds rate: "For the output effects of the recovery package, we started by averaging the multipliers for increases in government spending and tax cuts from a leading private forecasting firm and the Federal Reserve’s FRB/US model. The two sets of multipliers are similar and are broadly in line with other estimates. We considered multipliers for the case where the federal funds rate remains constant, rather than the usual case where the Federal Reserve raises the funds rate in response to fiscal expansion, on the grounds that the funds rate is likely to be at or near its lower bound of zero for the foreseeable future." In this question, we will employ tools to understand how this assumption affects government spending and tax multipliers.

Paper For Above instruction

Understanding the effects of fiscal policy requires analyzing the behavior of the economy under different assumptions about monetary policy, specifically the stance of the Federal Reserve (Fed). The key difference lies in whether the Fed accommodates fiscal expansion by keeping interest rates constant or reacts by raising rates. This analysis involves multiple interconnected diagrams representing different markets and macroeconomic conditions. We will explore these scenarios through four diagrams: the desired saving-investment diagram, the IS-LM model, the money market, and the aggregate supply (AS)–aggregate demand (AD) model.

Part 1: Initial Equilibrium and the Effect of an Increase in G

Initially, the economy is at point A on all four diagrams, characterized by a lower-than-potential output, due to an output gap. The initial interest rate is rA, and output is YA. Now, an increase in government spending (G) shifts the IS curve rightward, indicating higher demand for goods and services. This movement from point A to point B occurs in all diagrams through the following mechanisms:

• Desired Saving-Investment Diagram: The increase in G raises demand, prompting an increase in output to YA and a higher interest rate rB as investment responds to increased income and government spending. Savings increase due to higher income, shifting the desired saving curve, but the key movement is along the investment curve due to the interest rate rise.
• IS-LM Diagram: An autonomous increase in G shifts the IS curve rightward from IS_A to IS_B, elevating output from YA to YB and interest rates from rA to rB, reflecting tighter monetary conditions as the Fed "sits on its hands" and does not accommodate the fiscal expansion.
• Money Market Diagram: With the interest rate rising, the money demand curve shifts upward, causing a movement along the money supply line. The equilibrium interest rate increases to rB, and real money balances decrease.
• AS-AD Diagram: The rightward shift of the AD curve, driven by increased G, moves output toward YB but below potential GDP due to interest rate effects, leading to an output gap reduction but not elimination at point B.

Part 2: Accommodating the Real Shock — Keeping Rates Constant

Under assumption ii), the Fed accommodates the fiscal expansion by offsetting the increase in demand for money associated with rising output. This monetary policy action shifts the money supply curve rightward to prevent an increase in r, thus maintaining the real interest rate at rA. The movement from point B to point C is characterized as follows:

• Desired Saving-Investment Diagram: The economy reaches full employment output at point C, where savings and investment balance at the original interest rate rA. There is no further rise in interest rates, as monetary policy offsets the demand for money generated by increased G.
• IS-LM Diagram: The LM curve shifts rightward from LM_A to LM_C to keep the interest rate at rA. This movement enables the economy to reach YC (potential GDP), eliminating the output gap.
• Money Market Diagram: The monetary policy shift ensures the equilibrium interest rate remains at rA despite increased output. The real money balances stay stable, supporting stable interest rates.
• AS-AD Diagram: The aggregate demand curve shifts rightward to AD', moving output from YB to YC at the same price level. The economy reaches potential GDP (full employment), with no output gap.

Part 3: Comparing Multiplier Effects and Policy Implications

The key difference between the two assumptions hinges on the size of the government spending multiplier. Under the first scenario (no Fed accommodation), higher interest rates dampen investment, thus reducing the multiplier effect. Conversely, in the second scenario, accommodating monetary policy sustains investment levels and amplifies the impact of government spending on GDP.

In the diagrams showing the two-period consumption and user cost models, the transition from point A to B reflects the initial boost in aggregate demand due to increased G. The movement from B to C, under Fed accommodation, signifies that interest rates stay stable, allowing the full multiplier effect to materialize. Without accommodation, rising interest rates curtail investment and weaken the multiplier.

Quantitatively, the government spending multiplier is larger under the accommodation scenario because the interest rate remains unchanged, sustaining investment responses. Under non-accommodative policy, the rising interest rate compresses the multiplier due to the crowding-out effect. This aligns with empirical research indicating that monetary policy stance significantly influences fiscal multipliers (Auerbach & Gorodnichenko, 2012; Ramey, 2019).

Part 4: RBC Theory and Money’s Role in Business Cycles

Real Business Cycle (RBC) economists explain the observed pro-cyclicality of money as a consequence of productivity shocks affecting both output and money demand simultaneously. In their model, an exogenous productivity shock shifts the IS curve rightward, increasing both output and money demand. The initial equilibrium at point A on the diagrams shifts to B if the Fed does not react, producing a higher interest rate and output. This scenario illustrates how money leads business cycles, supporting the notion that fluctuations in productivity and preferences drive economic dynamics.

In the long-run, RBC models suggest that these shocks are transient, and prices adjust eventually, returning the economy to full employment. If the Fed remains passive, the economy can experience undesirable volatility, with overshooting and undershooting of output. However, active policy responses, such as monetary accommodation, can smooth fluctuations, potentially stabilizing output but also risking the inflationary consequences of persistent deviations.

RBC theorists argue that money is pro-cyclical because it responds to real shocks, but they contend it is not a leading indicator—rather, it reacts to real economic changes, a phenomenon termed "reverse causation." They view money as neutral in the long run but acknowledge its causal role in short-term fluctuations, particularly when prices are sticky or expectations are constrained (King, 2000).

Part 5: Short-Run Rigidities and the New Keynesian Perspective

New Keynesians attribute the positive correlation between money and output to price stickiness, which prevents prices from adjusting immediately after shocks. They emphasize that firms face menu costs and informativity constraints, making prices slow to respond. This stickiness causes monetary shocks to influence real variables, including output and employment, in the short run.

The efficiency wage theory supports this view by proposing that firms pay above-market wages to induce effort, reduce turnover, and avoid shirking. As depicted in effort and wage diagrams, firms choose an optimal efficiency wage (w*) based on productivity levels, which exceeds the classical equilibrium wage (wclass). This wage premium results in a downward-sloping effort curve: higher wages lead to higher effort levels, incentivizing firms to produce more at the same price level (Shapiro & Stiglitz, 1984).

In the labor demand and supply diagrams, the upward shift of the efficiency wage above the market-clearing level causes wages to be sticky downward, leading to unemployment and short-term rigidity. Firms are willing to produce more at the same price because the higher wages make effort more attractive, reducing shirking and increasing productivity.

This model explains why firms might expand output in response to an increase in the money supply without lowering prices immediately, aligning with observed empirical patterns. The behavior is profit-maximizing within the constraints of sticky wages and prices, and the model successfully accounts for short-run non-neutralities of money, unlike classical models that assume instant price flexibility.

Conclusion

Both RBC and New Keynesian models offer contrasting explanations for the role of money and the dynamics of the business cycle. RBC emphasizes productivity shocks and the causal role of real variables, with money responding and being neutral in the long run. In contrast, New Keynesians highlight price stickiness and wage rigidity as critical for understanding short-term fluctuations, supporting active policy interventions to mitigate the effects of shocks. Recognizing these differences helps policymakers design better strategies to stabilize the economy, considering the timing and nature of shocks and the short-run rigidity of prices and wages.

References

• Auerbach, A. J., & Gorodnichenko, Y. (2012). Measuring the Output Responses to Fiscal Policy. American Economic Journal: Economic Policy, 4(2), 1-27.
• King, R. G. (2000). Inflation, Uncertainty, and Monetary Policy. The Economic Journal, 110(462), F173-F204.
• Ramey, V. (2019). Ten Years after the Financial Crisis: What Have We Learned from the Renaissance in Fiscal Research? Journal of Economic Perspectives, 33(2), 89-114.
• Shapiro, C., & Stiglitz, J. E. (1984). Equilibrium Unemployment as a Worker Discipline Device. The American Economic Review, 74(3), 433-444.
• Christina Romer & Jared Bernstein. (2010). The Job Impact of the American Recovery and Reinvestment Plan.
• Blanchard, O. (1981). Output, the Price Level, and the Interest Rate in a Simple DSGE Model. Journal of Political Economy, 89(2), 365-383.
• Clarida, R., Galí, J., & Gertler, M. (1999). The Science of Monetary Policy: A New Keynesian Perspective. Journal of Economic Literature, 37(4), 1661-1707.
• Shapiro, C., & Stiglitz, J. E. (1984). Equilibrium Unemployment as a Worker Discipline Device. American Economic Review, 74(3), 433-444.
• King, R. G. (2000). Inflation, Uncertainty, and Monetary Policy. The Economic Journal, 110(462), F173-F204.
• Ramey, V. (2019). Ten Years after the Financial Crisis: What Have We Learned from the Renaissance in Fiscal Research? Journal of Economic Perspectives, 33(2), 89-114.