Wednesday, November 25, 2009

The multiplier under extreme circumstances

One objection often made to studies showing that the fiscal multiplier may be quite small is that the studies do not explicitly take into account the direness of the current economic situation. Now a new NBER working paper (early ungated version here) by Almunia, Bénétrix, Eichengreen, O'Rourke, and Rua attempts to do exactly that.

It is titled From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons.

Here is the abstract:

The Great Depression of the 1930s and the Great Credit Crisis of the 2000s had similar causes but elicited strikingly different policy responses. It may still be too early to assess the effectiveness of current policy responses, but it is possible to analyze monetary and fiscal policies in the 1930s as a “natural experiment” or “counterfactual” capable of shedding light on the impact of recent policies. We employ vector autoregressions, instrumental variables, and qualitative evidence for a panel of 27 countries in the period 1925-1939. The results suggest that monetary and fiscal stimulus was effective – that where it did not make a difference it was not tried. The results also shed light on the debate over fiscal multipliers in episodes of financial crisis. They are consistent with multipliers at the higher end of those estimated in the recent literature, consistent with the idea that the impact of fiscal stimulus will be greater when banking systems are dysfunctional and monetary policy is constrained by the zero bound.

This is potentially an important and fascinating finding. I am going to read this piece carefully over the holiday.

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