Thursday, November 04, 2010

Why "Multipliers" Aren't Infinite

Nick Rowe at "The Worthwhile Canadian initiative" writes that he is unable to explain why the effect of economic growth of fiscal stimulus isn't infinite given the existence of a "liquidity trap" (which is to say zero nominal interest rates).

While given the existence a "liquidity trap" under massive deflation may perhaps create some positive short term effects from deficit spending, it is in fact very easy to explain why there isn't an infinite effect of it, and why it usually isn't any positive effect at all..

First of all, even aside from the below mentioned problems, it takes time for people to engage in economic transactions, something which alone is sufficient to rule out an infinite effect.

And secondly, there is of course the issue of Ricardian equivalence. To the extent that people expect current deficits to result in future austerity, this will reduce their spendng. And do note that this is not just applicable to households but also companies.

And thirdly, higher nominal spending will mean higher prices, limiting the increase in real output from a higher nominal demand.

And fouthly, deficit spending will in any open economy cause the trade deficit to increase. This is one factor that Rowe recognizes, but he doesn't seem to realize that this alone explains deviations from infinity. And by recognizing only this, he misses the Ricardian equivalence and time factors.