Rethinking multipliers in a globalized world

Abstract

This paper uses the central tool of an investment-savings and monetary-policy model with an augmented Philips curve and presents a few extensions of that model to analyze the multiplier effects of macroeconomic policies in the United States. In doing so, the authors incorporate realistic assumptions in the model related to the recent financial characteristics of the global economy. The monetary policy reaction function embeds a new augmented Taylor-rule incorporating housing and stock prices and the credit lending rate. And the household consumption and firm investment decisions incorporate housing and stock assets and the credit market frictions. The equilibrium income is derived and compared with the actual nominal gross domestic product of the United States for the period 1990 to 2009. More importantly, fiscal and trade multipliers are derived and discussed. The main finding is that government spending, tax cut, and trade multipliers are relatively smaller in size when more realistic features are incorporated in the model. The model simulation shows that the model can track actual gross domestic product reasonably well. The model should be further improved before it could be used for policy exercises.

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Policy Research Working Paper
5277
Rethinking Multipliers in a Globalized
World
Raj Nallari
Leopold Engozogo Mba
The World Bank
World Bank Institute
Growth and Crisis Unit
April 2010
WPS5277
Public Disclosure Authorized
Public Disclosure Authorized
Public Disclosure Authorized
Public Disclosure Authorized

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Abstract
The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development
issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the
names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those
of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and
its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent.
Policy Research Working Paper 5277
This paper uses the central tool of an investment-savings
and monetary-policy model with an augmented Philips
curve and presents a few extensions of that model
to analyze the multiplier effects of macroeconomic
policies in the United States. In doing so, the authors
incorporate realistic assumptions in the model related to
the recent financial characteristics of the global economy.
The monetary policy reaction function embeds a new
augmented Taylor-rule incorporating housing and stock
prices and the credit lending rate. And the household
consumption and firm investment decisions incorporate
housing and stock assets and the credit market frictions.
This paper—a product of the Growth and Crisis Unit, World Bank Institute—is part of a larger effort in the department
to exchange knowledge with policy makers and practitioners on development policy issues. Policy Research Working
Papers are also posted on the Web at http://econ.worldbank.org. The author may be contacted at Rnallari@worldbank.org.
The equilibrium income is derived and compared with
the actual nominal gross domestic product of the United
States for the period 1990 to 2009. More importantly,
fiscal and trade multipliers are derived and discussed.
The main finding is that government spending, tax cut,
and trade multipliers are relatively smaller in size when
more realistic features are incorporated in the model.
The model simulation shows that the model can track
actual gross domestic product reasonably well. The model
should be further improved before it could be used for
policy exercises.

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Rethinking Multipliers in a Globalized World
by
Raj Nallari1
and
Leopold Engozogo Mba




1 Contact emails: Rnallari@worldbank.org and Lengozogomba@worldbank.org. The authors wish to thank
Aart Kraay for comments on an earlier draft.

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1.
Introduction

The aim of this paper is to analyze the fiscal-monetary-trade-and international financial
multipliers to better understand the pathways to global economic recovery. For this purpose,
we develop an open macroeconomic model which incorporates some realistic features.
First, the fiscal multipliers are derived after solving for the equilibrium income using the
combination of the good-markets, the Augmented Taylor Rule, and the Philips curve with
expectations. This model has the novelty of including housing and financial/stock assets in
household’s wealth function and firm’s investment decision while taking into account
financial market imperfections through the inclusion of the credit or lending rates in firms’
decisions to invest and central bank formulation of the monetary policy rule. Such a realistic
structural model can be used by developed and developing countries to assess the efficacy of
their policies.

The global economic crisis has brought about renewed interest among academics and
policymakers, particularly on fiscal multipliers. The Keynesian multiplier is the impact of
traditional macroeconomic policies, such as an increase in government spending, that is
“multiplied” by boosting private consumption by households and capital investment by
firms as they receive income from the initial round of fiscal stimulus. The multiplier effects
are important to assess the strength and speed of economic recovery in a country.
Therefore, the arguments are about the ‘size’ of the multipliers, which itself will depend
upon the structure, methodology and assumptions underlying the models.2 This paper
presents a simple but more realistic model to discuss the recent US financial and economic
problems, and the transmission of the crisis to other countries, argues that the sum of all the
multipliers on the global economy is likely to be quite small.

The challenge of raising aggregate demand is now a global phenomenon. To get an
understanding of the underlying processes, take the case of the US. Here, the fall in the
stock market and owner occupied real estate led to an erosion of household wealth by $10
trillion. This led to an estimated decrease in aggregate demand by about $600 billion

2 Examples of policy modeling include the IMF’s Global Economy Model (Bayoumi 2004), the Swedish
Riksbank’s RAMSES (Adolfson et al., 2007), the European Central Bank’s New Area-wide Model (Kai
Christoffel et al., 2007) and a few others who developed dynamic stochastic general equilibrium (DSGE)
models.

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annually, or about 3 percent of GDP, due to a fall in household spending by about $400
billion and production by $200 billion. Automatic stabilizers like a decrease in personal and
corporate taxes cushion the fall in aggregate demand by about a third, but still leaving a net
GDP gap of about $400 billion annually3. So the present challenge in the US alone lies in
policies that could potentially raise aggregate demand by about $400 billion annually.

In many advanced countries, including the United States, the scope of monetary policy to
forcefully affect demand is limited to interest rates. However, interest rates in many of these
countries are already at historically very low levels leaving little leverage for further use of
this instrument. In many emerging and developing economies, though central banks have
lowered interest rates, they have done so cautiously so as to maintain incentives for capital
inflows and external stability. Given the extent of the downturn and the limits to monetary
policy action, fiscal policy is regarded as being crucial in providing short and medium term
support to the global economy. However, while a fiscal response across many countries may
be needed, not all countries have sufficient fiscal space to implement it since expansionary
fiscal actions may threaten the sustainability of fiscal finances.

Despite many shortcomings, the IS-LM model has been one of the main tools for
macroeconomic teaching and policy analysis. The IS-LM model describes the aggregate
demand of the economy using the relationship between output and interest rate. In a closed
economy version, in the goods market, a hike in interest rate reduces aggregate demand,
usually investment demand and/or demand for consumer durables. This lowers the level of
output and results in equating the quantity demanded with the quantity produced. This
condition is equal to the condition that planned investment equals saving. The negative
relationship between interest rate and output is known as the IS curve.

The second relationship deals with the money market, where the quantity of money
demanded increases with aggregate income and decreases with the interest rate. As to
realistically capture the working of the monetary policies following the 1990s, the Keynesian
IS-LM model has been reviewed and opened road to the IS-MP model. Indeed, while the IS
curve is still incorporated, the Monetary Policy (MP) curve has replaced the LM curve
(Romer, 2000). Indeed while the monetary policy is captured by the level of the money

3 Feldstein (2009).