Journal of Monetary Economics 2 (1976) 501410. @ North-Holland Publishing Company

DOES FISCAL POLICY STILL MATTER?

A reply

Alan S. BLINDER

Princeton University, Princeton, NJ 08540, U.S. A.

Robert M. SOLOW*

MIT, Cambridge, MA 02139, U.S.A.

1. Introduction

Ettore Infante and Jerome Stein have produced a fair and painstaking review of our two articles, ‘Does fiscal policy matter?’ and ‘Analytical foundations of fiscal policy’ (henceforth, ‘Analytical’j. We find their section 2 very balanced and ver!’ accurate, and thank them for avoiding what must have been an irresis- tible temptation to refer to us by the first letters of our respective last names.

However, in sections 3 anti1 4, they suggest that fiscal policy rests on rather weak analytical foundations after a11 At the risk of sounding like inveterate Pollyannas, we disagree. As we stressed in ‘Analytical,’ there is still much to be learned about the quantitative dimensions and timing of the economy’s response to fiscal-policy actions. But *he theoretical channels and qualitative effects of fiscal policy seem relatively well established, at least as well established as any piece of macroeconomic theory.

We have divided our response into several sections. In section 2 we bring our views on the monetarist-Keynesian controversy up to date (circa spring 19X), and try to put the contribution of ‘Does fiscal policy matter?’ into perspective. Section 3 examines the puzzling results that Infante and Stein obtained with the ‘fiscalist’ model, and explains why we find them not so puzzling after all. In section 4 we restate - more clearly, we hope - the message of ‘Does fiscal policy matter ?,’ and show why we think the Infante-Stein critique misses the mark. Our biggest disagreements are saved for section 5, where we examine the way in which Infante and Stein relate the theoretical findings from ‘Does fiscal policy matter?’ to the results of large-scale econometric models. We find the analysis there at best misleading and at worst just plain wro::g*

*FinanciA support from the National Scierce Foundation is gratefully acknowledged.

502 AS. Blirtder and R.M. Solow, Fiscal policy: A rep/y

2. The monetarist-Keynesian controversy

The battleground of the monetarist-Keynesian war has shifted considerably since we wrote the two articles which Tnfante and Stein review here, thanks in part to a conference on monetarism organized by Stein.’ Indeed the shift has been so great th\at we wonder whether anything more than machismo and habit propels the controversy today.

In ‘Analytical,’ we defined monetarists as those who adhere to ‘the notion g g .

that fiscal policy unaccompanied by an accommodating morzctury policy is power- less to influence output or the price level’ (p. 62). By implication, everyone else was a Keynesian. While we believe that this category was not an empty cell in 1972, it is very close to being empty today. Kcynesianism, then, has triumphed.

But monetarism can also claim a victory. A few years ago, the consensus Keynesian view about the shape of the government-expenditure multiplier could probably be summarized by the quotation which Tnfante and Stein reproduce from Fromm and Klein (1973, p. 393): ‘Conventional textbook expositions generally depict real expenditure multipliers approaching positive asymptotes.’ The monetarists were vigorous dissenters from this consensus, and seem by now to have won a point. We may perhaps be forgiven for paraphrasing Friedman’s famous dictum, and stating that while we are now all Keynesians in the short ruE, those of us who are not dead in the long run are at least near- monetarists.

What then is the neo-Keynesian-cum-reconstructed-monetarist view of the operation of fiscal policy? In the short run, bo ‘. ?-financed deficit spending has its major effects on output; prices barely respond. As lags in the consumption and investment functions work themselves out, this stimulative effect reaches a peak after K(for ‘Keynesian’) quarters. In the meantime, wages and prices begin to rise, restricting the real money supply and otherwise depressing aggregate demand. The multiplier effect of real government spending on real GNP there- fore starts to decline, while the effect on the price level builds. Eventually, after M (for ‘monetarist’) quarters, the effect on real output is completely dissipated if the long-run Phillips curve is literally vertical. If not, there is a small positive effect on real output. But the effect on nominal output is not dissipated; the nominal multiplier should roughly approach the horizontal asymptote discussed by Fromm and Klein. 2

While a few hard-core monetarists and die-hard fiscalists probably remain (much as there are still loyal Japanese soldiers hiding in the bush in the Philippines), we believe that most macro-economists would accept the broad outlines of the preceding scenario. But there remains plenty to argue about. For while the remaining questions are not the stuff of which ideological crusades

‘See Stein (1976). 2The approach will presumably be one of damped oscillation, rather than monotonic

contergence, because high-order difference equations invariably have some complex roots.

AS. Blinder and R&t. Solow, Fiscal policy: A reply 503

are made, important issues remain unresolved. How large are the integers Kand M? What is the height of the peak real multiplier? What is the ultimate nominal multiplier? Since the economy is no doubt nonlinear, how do these answers change with variations in initial conditions? The answers to these questions make a great deal of difference. 3

The portions of our two papers which addressed themselves to the monetarist- Keynesian controversy circa 1972 sought to demonstrate that those monetarists who contended that fiscal policy actions had no long-run effect OIZ aggregate denmd were involved in a logical contradiction. We showed that either the long- run effect is bigger than the short-run effect or the response of the economy is explosive (in either direction). Zero effect is simply not a logical possibility.

The Infante-Stein critique does not refute this view. They are right, however, to challenge our notion that the unstable case could be ruled out on logical grounds. We must admit that a fair reader of our papers might come away with the view that: ‘Since the economic system we observe seems to be stable, Blinder and Solow necessarily conclude that the monetarist scenario cannot be cozect’ (Infante and Stein, p. 484). That was an error.

Infante and Stein are also correct to question the casual empiricism which *established’ the stability condition

1-T’ FB > -

T’ ’

where Fs is the IS-LM multiplier effect of bonds (B) on real output (Y), and T’ is the marginal propensity to tax and reduce transfers as income rises.4 For one thing, FB is not simply a transfer multiplier - a point Infante and Stein neglect in their section 4. An increment in B has effects like a transfer payment through the accompanying interest payments; but it also has wealth effects. Secondly, interest on the national debo is taxable; most other transfers are not. Thirdly, recipients of government interest payments mzy have much lower marginal propensities to consume than recipients of other transfers. Finally, we no longer believe that the empirical evidence supports our ‘guesstimate’ that T’ is at least one-ha1 f.

All of this adds up to the admission that the size of Fu is a serious empirical issue, not to be settled by our armchair speculation or anyone clse’s. It ma!’ well be that (1) is reversed. In that case, a government which stubbornly refused to finance budget imbalances at least partly by printing or destroyinr! rnonev could destabilize an otherwise stable economy. We imagine that mosi poverin?ents would not be so stubborn.

jNone of the evidence on the steepness and speed of adaptation of the long-run Phillips curve is entirely convincing, and prevailing views may change as the recsnt rathe special episode recedes.

40n this see Scarth (1976).

I)

504 A.S. Blinder and R.M. S’olow, Fiscal policy: A reply

3. The fiscalist model

Just as monetarism should now be a doctrine of the past, so should strict fiscaiism. If there were any doubts about that, the results obtained by Infante and Stein should have dispelled them. Since the paradoxical implications of the extreme fiscalist model (see their section 3.2 )may puzzle many readers who (like us) have been teaching this model to freshmen (and undoing it for sopho- mores) for years, let us take a few minutes to interpret their findings.

What happens when the government spends more and finances the deficit by issuing bonds in a model where prices are fixed (by assumption) and interest rates are fixed (by monetary policy)? Initially, output rises by the amount FG given by Infante-Stein’s eq. (30). But, so long as the induced tax receipts per dollar of spending - T’F, - are less than a dollar, a budget deficit will ‘occur, and more bonds will have to be issued. These bonds increase income further - by Infante-Stein’s eq. (31) - but still do not eliminate the deficit because each new dollar’s worth of bonds brings in only T’F, < T’F, < 1 in new tax revenues. In the fiscalist model, the economy explodes upward in a never-ending spiral.’ This model has no wealth effects, so there is nothing more to say.

What happens in the real world? For one thing, prices start rising, which reduces aggregate demand through Pigou effects, induced increases in real tax burdens, and the balance of trade. If these safeguards fail, supply constraints become operative. Alternatively, the central bank may stop pegging interest rates. None of these stabilizers is present in the fiscalist model. Infante and Stein state that ‘. . . the effectiveness of fiscal policy cannot be proven through this model’ (p. 488). We agree and certainly never tried to do so. Our use of the fiscalist model was limited to illustrating the computation of the weighted standardized surplus, a concept which applies equally well to more complex models? We would never have tried to analyze the economics of bond finance in a model in which the stock of bonds plays no role whatever. That is what Infante-Stein do; the results only show it is not a wise thing to do.

4. Does ‘Does fiscal policy matter?’ matter?

The rock-bottom model used both in our survey and the pulper ‘Does fiscal policv matter ?’ * is a little better than the fiscalist model, but only a little better.

%fante and Stein treat this as only one of uwo possible casts. There is also a stable case where the marginal propensity to consume (MPC) is less than one but the sum of the MPC and the marginal propensity to invest is greater than one. In this case, T’FG 3 1, SO that government spending leads to budget surpluses and the long-run multipliers d Y/dG and dB/dG are both negative. We do not find this case very interesting.

61nfante and Stein claim that our weighted standardized surplus concept ‘was analyzed on the basis of such a fiscalist case’ (p. 485). In fact, we only used the fiscalist model as the simplest possible illustratkl:, and observed that ‘the measure generalizes in an obvious way to a-mmodate a model of arbitrary complexity” (‘Analytical’, p. 23).

A.S. Blinder and R. M. Solorv, Fiscal po hey: A rep/y 505

In particular, it allows aggregate demand stimuli to peter out via interest-rate effects, but not due to price effects. Infante and Stein quote our conjecture that the conclusions we reach are robust to allowing an endogenous price level. This is true only if we stick to the static aggregate supply curve, P = P( Y),’

and that is what we had in mind at the time. As soon as we allow (as we must) P to depend on the capital stock, or let P adjust according to its own dynamic equation, the conjecture t’ails.

What, then, does the model show? We think Tobin and Buiter (1976) phrased it much better when they entitled their paper on the same subject. ‘Long run effects of fiscal and monetary policy on aggregate demand,’ rather than ‘Does fiscal policy matter?’ For the right way to interpret the assumption that P is fixed is not that we consider only the horizontal portion of the aggregate supply curve (though the analysis clearly holds there), but rather that we were studying shifts in the aggregate demand schedule relating Y to P. We showed that, in the stable case, fiscal policy has lasting effects on aggregate demand - effects which are, in fact, even bigger than the short-run IS-LA4 effects. This means that fiscal policy must matter for something. Whether this something is real output, or prices, or, more likely, some blend of the two, depends on what is happening on the supply side of the economy.

How are the output- and price-effects of fiscal policy modified during the transition from the short run (say, one or two quarters) to the long run(probably several years)? First, there are the lags in the IS-LM sector mentioned earlier. This factor leads to a rising path for both the rcal output multiplier d Y,‘dG and the price multiplier dPjdG. Second, the wealth adjustments caused by an unbalanced budget lead to still further growth in both multipliers as time passes. Third, rotation of the aggregate supply curve - which has a positive slope in the short run but gets steeper in the long run as expectations adjust - reduces the real multiplier over time while adding to the price multiplier. It would not be surprising if the resultant of these three forces (and others not mentioned here) leads to a real multiplier that rises to a peak and then declines, and a nominal multiplier, d(PY)/dG, that rises steadily to an asymptote.

The first and third of the effects cited in the previous paragraph were part of

the corpus of macroeconomic theory well before we wrote our two articles. The second, however, was not; which is why ‘Does fiscal policy matter‘?’ was written. In the process, the first aud third effects were assumed away, whicli may or may not have been a sound expositional device, but certainly was never meant to be taken literally. We wish we had made this more clear originally.

While our analysis clearlv omits some important factors, we think it has two worthwhile messages. And Lt seems to us that these messages, unlike the specific stability conditions, are very robust. The first message is that the CCO~O~:I_Y is more

‘III expositing our rock-bottom model, Infante and Stein mistakenly say that we used the spbol Y to denote nominal income. In fact, we used it for real income.

506 AS. Blinder and R.M. Solow, Fiscal policy: A reply

likely to be stable if deficits are financed by prhting money than if they are @awed by -floating bonds. The second message is that the long-run e$?ct of government spending on aggregate demand is greater when dejcits are bond- jinanced that when they are money-financed. Both messages are logical con- sequences of the fact that government bonds pay interest, while money does not.

Pnfante and Stein claim to have refuted these messages by ‘showing that the stability of the rock-bottom model does not imply either the positivity of this cumulative multiplier [the steady-state multiplier d Y*/dG] or that this multiplier is larger when deficits are financed through the sale of bonds than when the deficits are financed by the issuance of new money’ (p. 485). However, it takes only a little algebra - actually provided by Infante and Stein in their footnote 6 (p. 487) - to show that d Y*/dG is both positive and bigger under bond-finance than under money finance whenever the stability condition (1) is satisfied and

T’F, < 1. (2)

Condition (2), which holds automatically for the model in ‘Does fiscal policy matteV8 but which becomes an empirical issue when induced investment (I, > di is allowed, is not only plausible, but almost inevitable. It simply says that government spending does not Iead to a birdgct surplus. While WC would argue that (2) shot&l be assumed as a matter of course, a more fundamental point is that the mecharlrism which leads to our results operates in reverse if (2) is reversed. For then raising G leads to a budget surplus and retirements of government obligations, with consequent contractionary effects on aggregate demand. Under those circumstances, the whole notion of ‘bond-financed deficit spending’ loses meaning.

A direct corollary of the second message is that au open-market ptrrchase of bortds, while expansionary in the short r-m, is cori/r*actiortary irl tltc long run. Infante and Stein find this ‘an unusual result’ (p. 492), and suggest that: ‘Both neo-Keynesians and monetarists will be surprised by this direct implication of the rock-bottom model’ (p. 492). Furthermore, they assert, because of this result - the antithesis of the quantity theory - ‘serious questions and doubts naturally arise from the use of this simple model’ (p, 492).

We find it easy to explain the result.g In the short run (meaning here: ‘with stocks fixed’), the open-market purchase expands demand for the usual reasons.

8Pruof. In our model, I,, = l7’ = 0. So, using Infante-Stein’s eq. (9).

FG-1 = 1 -C,(l-T’)+&, where

us (y#$-L.) > 0.

FG-’ exceeds T’because aL, > 0, and 0 < T’ < 1 imply that

1 -C1+d, > T’tl -Cl).

9See ‘Does fiscal policy matter?,’ footnote 9, p. 327.

AS. Blinder and R.M. Solow, Fscalpolicy: A reply 507

But, with government spending and taxes unchanged, a budget surplus results. Either money or bonds must be retired to finince this’ surplus, and these actions have a contractionary impact on aggregate demand. We know that the cumula- tive contraction must overwhelm the initial expansion because the condition for budget balance requires

G+B = T( Y+B). (3)

With lower B and unchanged G in the new stock equilibrium, Y must be lower (ifthe model converges).

Those monetarists who have studied the important work of Brunner and Meltzer carcfuily will also feel at home with this conclusion. Brunner and Meltzer (1976) work with a model in which long-run output is fixed at full employment v bile P is free to ad-just. They find that ‘long-run equilibrium price level is /oI~Y~c(/ bv an open market purchase.’ The government budget constraint permits no other*conciusioi?. Fix P (as we did) and the result will npp:ar in the form of reduced real out!lut: fix Y (as Brunner-Mcitzer did) and the result will appear in the form of l&er P.

5. Rlzwocconomic theory :;i!d econometric models

Infante and Stein (section 4) find glaring discrepancies between the predictions of our theoretic;~i model and the policy multipliers derived by simulating empirical macro models. We ;lgree th;it there are major discrepancies, but draw rather different inferences from them.

Before examining the evidence, there is an important methodological issue. Suppose that a skii theoretical macro model and a large empirical model reach dramatic& different conclusions. Which do we accept ? To us, no general answer .

can be provided to this quAon. In each particular case, we must examine the reasons for the disagreement. Did the theoretical model assume away an empirically important phenomenon? If so, we would believe the empirical model. Was the econometric mode specified in a fundamentally illogical way? If so, WC would trust the theoretical model.

When we apply this rather eclectic methodology to the issues raised by Infante and Stein, we find that we must side with our theoretical specification (for re;tsons explained below). This is not terribly surprising. Why does anyone

ther with simple and unrealistic theoretical model? of the macroeconomy? imagine because simple analytical models have tight logical structures which

can be used to check on the rather unwieldy empirical models, and to suggest new effects that may be worth capturing.

Our analysis of long-run wealth effects is a case in point. Most of the econo- metric models surveyed by Infante and Stein omit wealth effects entirely, and trc;it government interest payments 1s exogenous. Very few pay attention to the

50s .:4 S. Blinder and R. ht. Salow, Fiscal policy: A reply

government budget constraint [see Christ (1971)]. How, then, can they be used to confirm or refute our theoretical notions?

Infante and Stein compare our theoretical notions to the findings of the econometric models on five questions. They conclude that the models ‘do not support the implications drawn by Blinder and Solow from the rock-bottom model’ (p. 499). Let us examine each of these questions in turn. Do Y and P react in the same direction ? The verdict of the models seems to be

%IO’ - probably not in the short run and definitely not in the long run. First, we would take issue with Infante and Stein’s identification of second-

quarter multipliers from econometric models with our ‘impact multipliers.’ Our impact multipliers refer to a hypothetical scenario in which all the lags in the IS-LM sector work themselves out, while P remains fixed. While P is nearly unresponsive to G within two quarters, empirical consumption and investment functions certainlv suggest that the IS-LM lags are far longer than two quarters.

Second, there is a transitory phenomenon that is always ignored by theoretical modli:ls. Short-run surges in aggregate demand lead to productivity improve- ments which hold down, and may even lower, prices. This is the reason why dP;dG is negative for a few quarters in most econometric models. Third, most econ,ometric moJe1 builders would admit that price-determination is one of their weakest links. WJien Fromm and Klein wrote the article which Infante and Stein use. kill models were demand-oriented, and paid almost no attention to the supply tide of the economy. In Wharton 111, for example, a stimulus to aggregate demand

wcrs prices for at least 4 years. Do mh’pIicr paths reach appropriate hits? We would expect (see footnote 1)

both real and nominal values to show damped oscillations towards limiting values which would be relatively small or zero for the former and substantially positive for the latter.

Infante and Stein use 40.quarter multipliers (except for the MPS model) as empirical representations of our theoretical long-run multipliers. It is well known. however, that these econometric models are designed almost exclusively for short-run analysis, and often exhibit unbelievable behavior if the computer is allowed to whir away long enough. In our view, 40,quarter multipliers tell more about the long-run behavior of difference-equation systems than they do about the U.S. economy. This is why we restricted our examination of results from the models to 12 quarters in ‘Analytical.’ We are, therefore, unimpressed by the fact that 40-quarter simul Itions are at variance with our theoretical notions.

Despite this, let us look at the evidence. Infante and Stein have the most trouble accounting for the real multipliers, dY/dG, which look bizarre by any- one’s standards (see their table 3). What is going on here? Inspection of Fromm and Klein’s table 5 shows that:

For the Brookings and DHL models, the simulations seem to be converging toward zero or a small positive value.

AS. Blinder and R.M. Solow, Fiscal policy: A reply 509

(2) The MPS model after 16 quarters gives the appearance of convergence. But those familiar with its properties know that it damps very slowly. If allowed to run 40 quarters, it would probably still be cycling.

(3) DRI and Wharton show the behavior that MPS would have shown: cycles which are either anti-damped or damp very slowly.

(4) The BEA model simulation looks as if the computer blew a fuse.

If we ignore the BEA model, these results do not look so bad after all.

In fact, they look better than they should, for most of the simulations reported by Fromm and Klein were based on strstaind irtcrements ift nomitzal govertfment spetding. ‘Real multipliers’ were computed by dividing the observed change in real GNP, quarter by quarter, by the observed change in real G. The latter falls endogenously over time as the government deflator rises. So the ‘real multipliers’ refer to u /urge initial incwasc in G f~~/low~d by a wccession of smal! decreases. It is no wonder, then, that such ‘multipliers’ may turn negative and take a long time to damp down.

Does the stabiiitv condition hold? Here Infante and Stein commit the same I

error we did in our (futile) exercise in casual empiricism - trying to use an empirical tax multiplier to represent FB. Furthermore, we repeat that two-quarter econometric multipliers are not the same as our theoretical impact multipliers.

DWS art oplw-market purchasr raLw Y and P in the short mu ‘? Infante and Stein, using some results tabulated by Christ (1975), find that Y generally rises but P often falls. The explanation for this ‘perversity’ probably lies in the short- run productivity gains cited earlier.

DWJ au opcmmarket ptrrchu.sc iowr Y arld P i/l th lotlg rrrlz ? Infante and Stein find that most of the models imply that Y and P rise instead. Our reasons for ignoring the 4O-quarter mllltipliers- of econometric models were explained previously. lo But, even if these were waived, the fact remains that none of the models contains the causal chain from budget imbalances to both future wealth and future interest payments, which is what makes an open-market purchase contractionary in our model.

6, Concluding commeet

Infante and Stein give the distinct impression that there is no convergence of views m the operation of fiscal policy. We think tl:,ere is convergence, on both the empirical and theoretical levels. The c%ef concliusions of our two papers are also implied by the Brunner and Meltzer model. When Blinder and Solow agree with Brunner and Meltzer, is there not convergence of views? It is Aso our

l”T‘he monetary-policy simulations tabulated in Christ’s (1975) table 4 actually 1hSt 36 quarters in the DRI and MQEM model.,, 16 quarters in the Wharton, 14 quarters in the Liu-Hwn (monthly) model, and 64 quarters in the Hickman-Coen (annual) model.

510 A.S. Blinder and R.M. solow, Fiscal policy: A reply

impression that a repeat in 1976 of the Fromm-Klein comparison of fiscal- policy multipliers would show the models much closer together. The current Wharton model looks much more like the MPS than it did then; DRI is now far less fiscalist; the Brookings model is a thing of the past.

The absurd results which Infante and Stein obtain with the fiscalist model show that it is no better, and no worse, than iMV = P Y. Even a model as simple as our rock-bottom model of aggregate demand does not have similarly absurd implications as long as ‘deficit spending’ leads to deficits rather than to surpluses.

When the discrepancies between our theoretical predictions and results from econometric models are held up to closer scrutiny, either the disparities look less significant or the econometric models fall apart. This does not mean that empirical results have supported our theoretical suggestions, only that the latter have never really been tested.

That some kind of consensus now exists does not mean that we have at last stumbled upon the truth. There are already new theoretical developments, surprising empirical findings and novel policy issues which raise the possibility that the conceptual underpinnings of fiscal policy may be quite different in the year 2000. But the undeniable fact that we 30 not know everything does not mean that we do not know anything. Looking back over the Infante-Stein critique remindc us of a sentence in ‘Analytical’: ‘We do not believe that the roof fell in, much less that the foundation crumbled’ (p. 11).

References

Blinder, A.S. and R.M. Solow, 1973, Does fiscal policy matter?, Journal of Public Economics 2, 319-337.

Blinder, A.S. and R.M. Solow, 1974, Analytical foundations of fiscal policy, in: A.S. Blinder et al., The economics of public finance (Brookings, Washington, DC) 3-l 15.

Brunner, K. and A.H. Meltzer, 1976, An aggregative theory for a closed economy, in: J.L. Stein, e&, Monetarism (North-Holland, Amsterdam) 69-103.

Christ, C.F., 1971, Econometric models of the financial sector, Journal of Money, Credit and Banking 3, no. 2419-449.

Christ, C.F., 1975, Judging the performance of econometric models of the U.S. economy, International Economic Review 16,54-73.

Fromm, G. and L.R. Klein, 1973, A comparison of eleven econometric models of the United Sta?es, American Economic Review 63,385-393.

Infante, E.L. and J.L. Stein, 1976, Does fiscal policy matter?, Journal of Monetary Economics 2,473~500.

Scarth, WM., 1976,, A note on the ‘crowding out’ of private expenditures by bond-financed increases in government spending, Journal od Public Economics, 5,385-387.

Stein, J.L., 1976, Monetarism (North-Holland, Amsterdam). Tobin, J. and W.H. Buiter, 1976, Long-run effects of fiscal and monetary policy on aggregate

demand, in: J.L. Stein, ed., Monetarism (North-Holland, Amsterdam) 273-309.