Now that the dust has (kind of) settled on exactly what is and is not in Gerald Friedman’s interpretation of the Sanders economic plan, I thought it useful to contrast the textbook (at least the one I use, Olivier Blanchard/David Johnson‘s) view of how a fiscal stimulus works, versus that in which a one-time spending increase yields a permanent increase in output, in a graphical format.

Textbook

In Figure 1, I depict steady state with output at the natural level/potential GDP, and price level at P16 (to denote price level in FY2016). I assume for simplicity that the output gap is zero; I myself believe it’s somewhat smaller, maybe around -2 to -3 percentage points of potential GDP.

In FY2017, the AD curve is assumed to shift out due to an increase of government consumption and investment equal to about 0.8 percentage points of GDP; I assume this is a constant shift over the subsequent years, relative to where government spending was. The Fed accommodates somewhat, so part of the shift is due to increased money supply. The white arrow denotes the shift.

Notice that in the short output rises to FY18. Ignoring lags due to the spending multiplier taking time (the outside lag, in macro parlance), the AD curve stays where it is for the subsequent periods through FY2022.

Over time, note that the aggregate supply curve adjusts upward. That’s because price expectations are adaptive (either because the underlying expectations process is adaptive, or because of nominal rigidities and nominal contracts that prevent instantaneous price adjustment), so the expected price level ratchets upward. As this happens, the real money supply shrinks, pushing up interest rates, so that investment falls. There’s a movement along the AD curve, and finally the AS curve stops shifting when the natural level of output is restored. In this sense, the model is one where the economy is self correcting.

In this textbook model, a fiscal stimulus delivers a temporary — and not necessarily persistent — increase in output above potential. This pattern matches the outcome discussed in this post.