In your intermediate macroeconomics course, government expenditures and the money supply were treated as exogenous, in the sense that the variables could be changed to conduct economic policy to influence target variables,

but that these variables would not react to changes in the economy as a result of some fixed rule. The St. Louis Model, proposed by two researchers at the Federal Reserve in St. Louis, used this idea to test whether monetary policy or fiscal policy was more effective in influencing output behavior. Although there were various versions of this model, the basic specification was of the following type:

?ln(Yt) = ?0 + ?1?ln mt + ... + ?p?ln mt-p-1 + ?p+1?ln Gt + ... + ?p+q?ln Gt-q-1 + ut

Assuming that money supply and government expenditures are exogenous, how would you estimate dynamic causal effects? Why do you think this type of model is no longer used by most to calculate fiscal and monetary multipliers?

What will be an ideal response?

Answer: If the money supply and government expenditures were exogenous, then a distributed lag model could be used to estimate the dynamic multipliers and cumulative dynamic multipliers using OLS. The coefficients in the above equation are then the dynamic multipliers. To obtain the h-period cumulative dynamic multipliers, all coefficients over the h-periods have to be added up. There is an alternative form for the above equation which allows for statistical testing of the cumulative dynamic multipliers. This involves differencing the regressors with the exception of the last lag, p and q, in the above equation. The coefficient on the p and q lagged regressor then represents the long-run cumulative multiplier. The OLS estimator of the coefficients in the above equation is consistent. However, the errors are likely to be autocorrelated since omitted variables from the above equation are probably serially correlated themselves. In that case the OLS standard errors are inconsistent and statistical inference based on these standard errors will be misleading. To avoid this problem, heteroskedasticity- and autocorrelation-consistent standard errors can be calculated. The reason why this type of model is no longer used by most to calculate fiscal and monetary multipliers is that researchers are not willing to assume that the money supply and government expenditures are exogenous. Both monetary and fiscal policy takes into account current and future expected output growth in setting their policy instruments, which are therefore endogenous.