I thought it might be useful to give an example of why I find thinking about a representative agent and rational expectations gives more plausible answers than using pre-microfoundations textbook analysis. It is an example where I’m genuinely curious about what heterodox economists who condemn using representative agents with rational expectations would do instead. As this is a post I’ll keep things as simple as I can and leave out most caveats and qualifications.OK my analysis. I will start with the original IS-LM model in a closed economy. That is I will assume that investment depends only on the nominal interest rate (and that there is only one nominal interest rate which is the same for all maturities). This would be enough to conclude that investment is constant, since the economy is at the ZLB.
The question is quite topical: what is the impact on output of a balanced budget increase in government spending in an open economy stuck at the zero lower bound (ZLB)? Well the first thing we have to do is ask whether the increase is permanent or temporary. If it’s permanent, if the import content of government spending is similar to consumer spending, and if taxes are lump sum, the answer is nothing. As the tax increase is permanent then consumption falls by the same amount, with no net impact on the demand for domestic output. That is pretty obvious, although anyone using a first year textbook would get this wrong (because they would have the mpc<1).
If the government spending increase is temporary, then the tax increase is also temporary. Thinking about an optimising consumer immediately gets us the result that consumption will initially fall by less than government spending, so there is a short run net increase in demand. (I am assuming that investment is unchanged, for standard reasons described here.) Higher demand raises output and income. If inflation does not change we get a multiplier that would be one if there were no imports. The analysis without imports is here, but we do not need it to show that output must rise.
In an open economy, we need to ask what will happen to the exchange rate if we have a temporary balanced budget increase in government spending, lasting no longer than the period interest rates are stuck at zero. Everyone remembers their Mundell Fleming – under flexible exchange rates fiscal policy is ineffective, because the exchange rate appreciates to crowd out the additional demand. But that is completely wrong in this case. Agents in the foreign exchange markets will note that there is going to be no increase in interest rates and no change in the steady state (so no long run appreciation or depreciation), so there is no reason for the exchange rate to move in the short run either. There is no crowding out through the exchange rate, so the analysis in the previous paragraph stands.
This is pretty simple stuff, but it gives different – and in my view better - answers than many undergraduate textbooks. And both the representative intertemporal consumer and rational expectations were central in getting the answer. Now you may want to complicate in various ways, but that normally means building on this analysis rather than overturning it.
So this is microfounded intertemporal macro telling us that a balanced budget fiscal expansion works at the ZLB. If you think this is obviously wrong because I’ve assumed all-embracing representative actors equipped with superhuman knowledge and forecasting abilities, tell me how you would do the analysis differently.
The IS-LM model implies that output will increase by the increase in government spending. Pre-tax income will increase by an equal amount. After tax income will be unchanged and consumption will be unchanged. The national accounts identity checks.
OK now what happens if the economy is open ? The standard Mundell Fleming argument, based on the assumption that the economy is not at the ZLB. is that the shift in the IS curve causes and "incipient" increase in the interest rate as the economy attempts to move up the upward sloping LM curve. This causes and appreciation of the domestic currency so that the increased government spending causes decreased net exports and no change in GDP. This argument has no relevance given the assumption that the economy is at the ZLB. The Mundell-Fleming analysis in this case is that GDP i remains 0 no matter what so the economy stays on the BB curve (bond market equilibrium) and there is no change in the exchange rate. The multiplier is less than one, because some of the increased demand spills over into increased imports. The analysis is qualitatively similar to Wren Lewis's analysis of a temporary balanced budget spending increase. They are the same if the spending increase lasts and instance. Wren Lewis asserts that the effect is smaller the longer the spending increase lasts shrinking to zero if it is permanent. The Paleo Keynesian analysis asserts that the effects are the same no matter how long the spending increase lasts.
I know of no evidence that the effect of a permanent spending increase is different than the effect of a temporary spending increase. In particular, I know of no evidence that, given disposable income (hence net of taxes) budget deficits are associated with lower consumption as they would be if consumers rationally anticipated higher future taxes as a result.
OK moving on a bit, after 1937 paleo Keynesians decided that investment is best fit by a flexible accerator meaning it increases if real gdp grown and decreases in the real interest rate. This implies a closed economy multiplier greater than one given the GDP increase. If one adds a Phillips curve, one also expects higher inflation than otherwise so lower real interest rates at the ZLB and an additional increase in GDP.
So what do I think ? I do not believe that there would be a detectable difference between the effects of permanent and temporary spending increases. For one thing, I have no idea what a reasonable forecast of future spending would have been so I have no idea what agents should have anticipated. I mean I have no guess whether past fluctuations in government spending were perceived to be permanent or temporary and would not be able to make that guess even if I assumed rational expectations. It is worth noting that many commentators and such tell Paul Krugman that temporary spending increases always turn into permanent spending increases. This is false. If one assumes that average people are better informed than policy intellectuals, then one would guess that temporary spending increases have a different effect than permanet spending increases. if not, and if one wanted micro founded macro, one would guess that temporary spending increases have no effect on GDP.
I'd guess people have only the vaguest notions not only of future spending but also of current spending. In any case, polls have demonstrated that US residents don't know about recent changes in taxes http://www.cbsnews.com/blogs/2010/02/12/politics/politicalhotsheet/entry6201911.shtml . I have not detected any connection between aggregate consumption and any events in the future (differences in events say 5 years in the future outcomes would be positively correlated with 5 year ahead expectations if people had rational expectations).
Therefore I certainly expect a positive multiplier. For the USA (a large economy with low imports compared to GDP) I would expect a multiplier slightly greater than one.
I'd guess that the spending increase would cause a slight depreciation. I guess some FOREX traders use the rule of thumb that exchange rates move to cause the balance of trade to return to normal and so sell domestic currency denominated assets when net exports decrease. Also I think that some FOREX traders think that government spending is bad and depreciation is bad and bad things go together. I don't think there are as many (weighted by risk bearing capacity) who make the opposite guesses. I sure wouldn't bet on this guess.