Models and Multipliers

Can expansionary budgetary policy boost employment? Ten years ago almost every economist would have answered “yes” to this question. Now there is an important conflict in the debate on economic policy. The conflict is between the results of theoretical and empirical multiplier analysis on the one hand and, on the other, beliefs of policy advisers about the need for tight budgetary policies which help to bear down on inflation despite uncomfortably high unemployment. This paper examines this issue with the aid of the RBA79 model of the Australian economy. The usual versions of this model (and all others in existence) have fiscal multipliers for output and employment which are positive for many years. The paper shows that it is relatively simple to adjust the assumptions of the model so that increases in real government spending produce increases in output and employment for only a couple of years. In the process, considerable inflation is generated, and this has strong adverse effects on activty in the medium term. The assumptions examined are associated with the reaction of inflation to increases in government spending and the effects of inflation and/or increases in government spending on demand and supply in the goods market. The approach consists of changing selected parameters in the model, in directions dictated by economic theory and a priori reasoning. Simulation analysis is then used to explore the implications of changing these assumptions. In short, RBA79 with changed assumptions produces results more in line with the intuitions of policy makers than the results of other models. The most interesting aspect of this is that the revised assumptions may be more appropriate for current conditions than the assumptions used in conventional multiplier analysis.