Alex Douglas in "More on Keynesianism, MMT and interest rates":
Central banks, outside the ZLB, have the power to keep the economy at the full employment level with inflation at a target level. Given this, the New Keynesian conclusions follow, regardless of how the state finances its spending.
It works like this: if we’re outside the ZLB and the central bank is doing its job, we’re at full employment with inflation on target. If the state engages in new deficit spending, the extra spending threatens to drive inflation over target. To avoid this, the central bank must raise the interest rate to suppress enough private spending to make room for the new public spending.
It follows that public deficit spending crowds out private investment, just as the textbooks say.
If We Assume Output Is Maximised...Defining "full employment" is an interesting question. But let us keep things simple, and assume that the current output is fixed at 100 "units," (which are a basket of goods and services, and is a real quantity, not nominal) of which 20 units are government spending.
What happens if the government increases its spending to be 22 "units"?
Since we assume that maximum output is 100 units, and there is no reason for total output to fall, the implication is that private consumption drops to 78 units (from 80). The multiplier on government spending to total GDP is 0. All that has happened is that the government share of the economy has increased, at the expense of the private sector (by definition).
Such an outcome is perfectly well understood by Functional Finance (primer), and MMT largely follows Functional Finance. In other words, this is not a point that is disputed by MMT (properly understood).
What If We Want To Model What Happens To Output?The analysis I have in the previous section was obviously dodgy. Assuming that output is fixed at 100 units hardly makes sense, and does not even seem to be supported by the mathematical framework used by New Keynesian models.
What we need to do is to actually run the full mathematical model, and see how variables are affected by the change in government spending.
This is the point where the hand-waving starts. Even if we grant all of the obviously incorrect assumptions embedded in New Keynesian models, I still have not seen a worked out solution. The usual dodge is to linearise (model the effects of small disturbances to the baseline scenario) -- which obviously is invalid, since we are making a macroscopic change to the baseline economic scenario. The usual hand waving about changes to fiscal policy is to assume that monetary policy cancels it out (or Ricardian Equivalence does the job), so we can ignore modelling its effects. (The scientific method in action!)
I realise that a fully worked out solution might exist somewhere. However, it is remarkably well hidden, given that it would be quite interesting to study. The reality that mainstream economists revert to hand waving about full employment, instead of actually demonstrating the results within a simulation, reinforces my skepticism.
(c) Brian Romanchuk 2016