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introducing forward-looking behavior by consumers and firms planning for
the future changes the dynamics and magnitude of Keynesian multipliers.
Forward-Looking Models with Rigidities
Many modern macroeconomic models combine forward-looking
behavior with some form of slow-moving prices or wages, sometimes
called “New Keynesian” models. In normal times, when monetary policy is
unconstrained and interest rates can vary, these models tend to imply fiscal
expenditure multipliers that are positive but smaller than one, as shown for
instance by Cogan et al. (2010) and Coenen et al. (2012), in part because of
increases in the interest rate from monetary policy which partially offsets the
fiscal expansion.
The onset of low interest rates has spurred considerable interest in
how these models perform when monetary policy is constrained by the
zero lower bound, that is, when the nominal federal funds rate falls to
zero, as in the recent recession. For instance, Eggertson (2001), Christiano,
Eichenbaum, and Rebelo (2011) and Woodford (2011) have shown that
when nominal interest rates are near zero, government spending can be
particularly effective and generate spending multipliers that are greater
than one; at the zero lower bound, expansionary fiscal policies can increase
inflation expectations and thereby reduce real interest rates, which spurs
investment and consumption, and monetary policy does not counteract
fiscal policy. Coenen et al. (2012) simulate the effect of the Recovery Act
spending in some forward-looking models with rigidities, both conventional
models (such as Smets and Wouters (2007)) and models augmented by the
zero lower-bound effects. Their results show that the standard models imply
a notable increase in output for several years, but with multipliers smaller
than one, while the models augmented by zero-lower-bound effects imply
multipliers that are much larger than one over the first few years.
The 2007-09 recession was unusual both because the Federal Reserve
was at the zero lower bound and because of its severity. This severity raises
the specter of high unemployment and—because the path to recovery from
a deep shock is long—unusually long spells of unemployment. Long-term
unemployment can lead to deterioration of skills and to stigmatization,
which makes finding employment even more difficult. For these and other
reasons, the longer the spell of unemployment, the less likely is an individual
to find a job in any given month, and the more likely he or she is to
remain unemployed or stop looking for a job altogether. This can lead to
a vicious circle: persistent slack demand means many people out of work
and long spells of unemployment, which in turn reduces the chances of the
unemployed finding a job, which perpetuates slack and further lengthens
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