Krugman's Fiscal Stimulus model

Paul had written a two factor model to explain fiscal stimulus in the face of a liquidity trap, and Robert Waldman suggested I go over this paper, which I do now.

Without damaging Paul's reputation too much, I will start with the summary of his paper. Paul is dealing with the situation in which consumer demand today suddenly drops from yesterday, and goods and services are mis-priced from what the producers expected. In this case, the equilibrium condition, ( using Paul's terms) when the utility of all goods and services match, will result in an economy smaller today than the economy yesterday. That is, equilibrium is forcing the economy to shrink with the interest rate being computed to a negative value.

If we ignored government, for the moment, then the natural policy for the monetary authority would be to remove money from the system thus removing the liquidity trap, and settling for the lower equilibrium output. If this were possible, then the IS/LM curves would shift to represent the lower equilibrium and we have the liquidationist approach.

If we will not or cannot move the economy to a lower equilibrium, then what would be a optimal fiscal response? Paul points to the reduced marginal cost of moving government projects forward in time, or possibly starting new government projects, with the expectation that government projects have lower marginal cost today than they would have tomorrow. The drop in consumer demand releases resources and lowers the cost of government projects.

Should the optimum fiscal policy bring us to a new and better equilibrium or smooth over the transition to a lower equilibrium or try to restore the prior, stable equilibrium? To smooth over an equilibrium change, either up or down, the government need simply write an insurance policy for the producers, call it the dis-equilibrium insurance policy, like unemployment insurance or Hank Paulson's large payments to banks. Hiring people in this case makes no sense if they are well covered by dis-equilibrium insurance.

Then there is the possibility that government has projects that increase the utility of public goods and restores equilibrium to a higher output level. If a constraint of some public good is well known, then we are not, by definition, in a liquidity trap, consumers and government economists would be jointly deploying the new public goods and interest rates would not indicate a contraction.

That leaves one possibility, government economists knows what the future equilibrium points are and the consumer does not. In this case, fiscal policy can be expansionary.