State Dependence of Fiscal Multipliers: The Source of Fluctuations Matters, together with Mishel Ghassibe
Abstract
We develop a general analytic theory of state-dependent fiscal multipliers in a framework featuring interaction between three empirically relevant goods market frictions: idle productive capacity, unsatisfied demand and price rigidity. Our results generate a novel prediction: the cyclicality of fiscal multipliers is pinned down by the source of economic fluctuations. In particular, we show that policies that stimulate aggregate demand, such as government spending and consumption tax cuts, have multipliers that are large in demand-driven recessions, but small and possibly negative in supply-driven downturns. On the other hand, policies that boost aggregate supply, such as cuts in taxes on labor income, firms' payroll and sales, are ineffective in demand-driven recessions, but powerful if the downturn is driven by supply factors. Spending austerity, implemented by a reduction in government consumption, can be the policy with the largest multiplier in severe demand-driven booms and supply-side recessions, provided the labor market is sufficiently rigid and insensitive to tax cuts. Econometric analysis that conditions the estimation on the source of fluctuations detects significant state dependence of fiscal multipliers, congruent with the predictions of the theoretical framework.