Question

1. This question is based on the article, “The COVID-19 Fiscal Multiplier: Lessons from the Great Recession,” by Daniel J. Wilson, published on May 26, 2020, by the Federal Reserve Bank of San Francisco as part of its Economic Letters series. The article tries to assess the potential economic impact of the fiscal response to the COVID-19 pandemic. It draws parallels between the fiscal responses to the current downturn and to the Great Recession of 2008-2009 to estimate the potential range of the current fiscal multiplier and, thus, assess the extent of economic recovery in the coming quarters.

1. According to the article, how do the sizes of the fiscal responses to the current downturn and to the Great Recession compare in terms of dollar value and as percent of GDP? [8]

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2. According to the article, which component of the recent stimulus package had no counterpart in the 2008-2009 stimulus package? If that component is set aside, how does the composition of the rest of the fiscal response to COVID-19 compare with the composition of the fiscal response to the Great Recession? [8]

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3. The article mentions that the fiscal multiplier rises as the marginal propensity to consume (MPC) increases. Why does a rise in MPC increase the fiscal multiplier? [8]

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4. According to the article, why is the MPC higher for “liquidity-constrained” households compared to those that have liquid assets or can easily borrow when needed? [7]

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5. According to the article, the 2020 fiscal stimulus package amounts to about 11% of the 2019 US GDP. Given the article’s conclusion about the range of the fiscal multiplier under current conditions, how much the US GDP is expected to rise in the next couple of years as a result of the fiscal stimulus? [8]

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6. The 2020 fiscal stimulus package and the Fed’s actions that have used highly expansionary conventional and unconventional monetary policy tools have raised the prospects of the US economy and have helped the US stock market to recover quite strongly. They have prevented many other asset prices from falling. Would the impacts of the fiscal and monetary stimulus policies on asset prices help or hinder economic recovery in the US this year? [7]

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Extra Points Question: The article points out that the fiscal multiplier is found to be higher when the interest rate is at the zero lower bound (ZLB) compared to the situation when it is above zero and is not kept constant by monetary policy. What factors may explain the higher fiscal multiplier at the ZLB? Please use the IS-LM model to make a case for your answer

Answer 1

a. As a response to COVID 19, the discretionary fiscal responses are likely to add about $2.4 trillion, approximately 11.2% of 2019 GDP, to the federal deficit, occurring mainly over the next year. wheras, the 2019 deficit was $984 billion, 4.6% of GDP. on the other hand,the discretionary stimulus during the Great Recession was about 7.5% of GDP that stemmed from $840 billion American Recovery and Reinvestment Act (ARRA) of 2009 (CBO 2015) and $170 billion in tax rebates from the 2008 Economic Security Act, along with automatic stabilizers and reduced tax revenue.

b.The composition of the two fiscal stimulus programs is very similar except for the current PPP, which had no match in the Great Recession. PPP is paycheck protection program whixh aims at providing small businesses with forgivable loans to cover payroll costs.

the similar aspects of fiscal stimulus includes

1. income transfers- it consist of money from the government in the form of benefits (= payments for people who cannot find a job or are too ill to work), subsidies (= money given to reduce the cost of producing food, a product, etc.), etc

2. government purchases :Government purchases of goods and services is the canonical type of government spending and another way to pump money in the economy.

3.Transfers to state and local governments. it means transfer of funds to state governments by central governement to compensate in reduced taxes and other governement revenue income and to help in maintain a balanced budget. An important issue for determining the multiplier on transfers to state and local governments is the “flypaper effect.” This refers to the portion of federal money state and local governments receive that they actually spend as opposed to saving or financing tax cuts. This is analogous to the MPC for individual transfers.

c. MPC refers to the proportion of income that a consumer spends on actual consumption from the market  while remaining of the income  on savings or paying existting debts

the MPC during the current crisis could be quite high for many households, for example those experiencing layoffs, as they use transfer funds for basic needs such as food, housing, and utilities. However, many other households, for example employed or retired, may have an MPC closer to zero because many types of spending are less available due to social distancing. In general, the more severe and prolonged the economic downturn, the higher the share of households that will be liquidity constrained and the more households will need to use transfer income for basic needs, pushing up overall MPC as they would not have another source of liquidity

d. As the marginal propensity to consume out of individual transfers is particularly high when unemployment is high and liquidity constraints bind, implying fiscal multipliers near or above one. Second, the marginal propensities to spend out of federal transfers by state and local governments are particularly high during times of fiscal strain, suggesting at least a dollarfor-dollar pass-through to spending. Third, the fiscal multiplier on government spending when monetary policy is by the zero lower bound is around 1.5. Overall, the evidence suggests that the output boost from the current fiscal response is likely to be large.

e.an increase in government taxation with no change in the spending counterpart leads to a fall in asset returns as it discourages investors from participating in the stock market. Moreover, a rise in government debt increases the interest rate and, therefore, lowers the present discounted value of the cash-flows generated by stocks. As a result, it negatively impacts on stock markets. The rise in borrowing costs may also induce a fall in private spending (i.e. consumption and investment) via the so called “crowding-out” effects which, in turn, affect stock markets by reducing household’s wealth (Laopodis [2007]). Fiscal consolidations that lead to a permanent and substantial fall in government debt or signal sounder fiscal behaviour are also typically related with increases in stock market prices (Ardagna [2009]). Similarly, fiscal policy measures (i.e. changes in expenditures or taxes that lead to a budget deficit or surplus) may impact on sovereign risk spreads and financial markets may also be influenced by the interaction between fiscal variables and political institutions (Akitoby and Stratmann [2008]). For instance, the occurrence of sustained budget deficits may entail additional risks such as the loss in (domestic and foreign) investor’s confidence and a shift of asset portfolios away from home-currency assets and into foreign-currency assets, thereby, further leading to a fall in stock prices. Additionally, an increase in the government deficit can bring a rise in long-term interest rates, a higher risk premium on long-term bonds and more volatility in bond yields. therefore a rally in stock mrket induced by fiscal stimulus will increase kinvestors income ane help in economic recovery.

bonus question

The presence of the lagged shadow policy rate in the interest rate feedback rule reduces the government spending multiplier nontrivially when the policy rate is constrained at the zero lower bound (ZLB). In the economy with policy inertia, increased inflation and output due to higher government spending during a recession speed up the return of the policy rate to the steady state after the recession ends. This in turn dampens the expansionary effects of the government spending during the recession via expectations