Government Spending Multipliers and Recessions October 2010

Theoretical Results on the Gov. Spending Multiplier “crowding out”: dc/dg < 0  dy/dg < 1 –Private and public sectors compete for resources –Prices, entry or some other mechanism causes one sector to economize when the other sector expands –Does not apply to transfers Marginal tax rate effect: by itself, reduces output –Substituion effect from taxes –Substitution effect from means-tested spending –Applies to either spending or transfers Wealth effect: by itself increases output –Multiplier can appear larger than one if spending profile slopes up –Multiplier can be larger than one if increased work stimulates complementary investment

Theoretical Results on the Gov. Spending Multiplier New Keynesian view –Crowding out and MTR effects dominate in the long run –These mechanisms do not operate in a recession because of sticky wages or prices

Empirical Results on the Gov. Spending Multiplier Non-recessions –Wartime dy/dg  (0,1) –Transfers multiplier less than zero –Mixed results for peacetime purchases, but government spending may be increasing because output increases, rather than the other way around Recessions –Not many government spending shocks during recessions –Can examine the mechanisms that create crowding out and MTR effects

Does Recession Labor Supply Matter? practical public policy questions –Can U.I. increase employment during recessions, even while it “normally” reduces employment? –Means-tested benefits? –Almost every major item in the “stimulus law” raised marginal income tax rates on some segment of the workforce. Even some of the “tax cuts” –Even if labor supply incentives matter during recessions, might they matter less? Key assumption of old and new Keynesian models: output and employment are primarily demand determined

Unemployment Benefits $ per week, cumulative benefits $ per week cumulative benefits

UI and the Budget Constraint disposable income

Seasonal Cycles have Analytical Advantages Large –e.g., real GDP 5-8 percent less in Q1 than Q4 (today that’s a drop of $200 - $300 billion) –armies of students: more than 20 million persons age are enrolled in school during the academic year, but potentially available for work in the summer almost 14 million aged compare to 1.4 million persons on active duty in the U.S. military Seasonal impulses occur even in recessions Some seasonals can be attributed to supply vs demand Does Christmas demand run into any (fewer) supply constraints during a recession? Do recession economies create any (fewer) jobs for teens during the summer?

labor supply labor demand Wage Floor & Job Shortage $ per hour “Unemployed” = would accept a job paying the going wage

New Keynesian Version Demand with flexible P Demand with fixed P

Non-Wage Mechanisms Search Monopoly labor union: could “over-shift” supply –i.e., if recessions are times when monopoly union power is especially important, then employment could be more sensitive to supply during a recession Job characteristics model  unemployment can exist even while labor supply matters at the margin, perhaps even more than it would without unemployment

labor supply labor demand Non-wage Mechanism $ per hour wage mechanism is preferred “Unemployed” = would accept a job with the characteristics that exist without the wage floor

Nested Econometric Model Seasonal a shifts supply and demand Business cycle X both shifts supply and demand, and changes their slopes To the extent that the season differentially shifts supply and demand, employment seasonal calculated from reduced form potentially depends on the business cycle:  is the “incidence parameter”. Does it vary over the business cycle?

Seasonally Unadjusted Data Household Survey: Monthly employment by age group Establishment survey: Monthly employment by industry Monthly Retail Sales Summer seasonal –deviation of log July value from May-Sep average –May-Sep average is weighted in years when the Census Bureau reference week in July is not equidistant from May and September reference weeks. (these weights have almost no effect on the results) Christmas seasonal –deviation of log Nov-Dec value from Oct-Jan average –also December only version –similar results if Jan-Feb is compared to Dec-May interpolation

Reasons to Think Summer Supply Shift Exceeds Demand Sheer numbers –20+ million students aged released from school –What possibly could be a summer demand shift of that size? Even doubling the size of the military would be smaller If demand shifted so much: –why are summer unemployment rates above normal for all age groups? –why isn’t summer employment high for ages 25+? –why aren’t Q3 teen weekly wages higher than in other quarters? –why does the summer employment seasonal mimic the school enrollment pattern?

Conclusions Economic theory does not tell us whether labor supply would matter more or less during a recession. Economic theory does not tell us whether labor demand would matter more or less during a recession. the summer and Christmas seasonals for employment and unemployment are essentially the same number of log points in recession years and non-recession years Even in 2008 and 2009 Results contradict old- and new-Keynesian models Results are consistent with the view that labor markets are especially “distorted” during recessions