Evaluation of ARRA (2009) Using DGE and Dornbusch–Kalecki Models
Evaluation of ARRA (2009) Using DGE and Dornbusch–Kalecki Models
Introduction
The American Recovery and Reinvestment Act (ARRA) of 2009 represents a significant fiscal stimulus introduced to stabilise output and employment following the global financial crisis of 2007–2008. The macroeconomic effects of such large-scale government spending vary considerably depending on the analytical framework applied. This essay compares the interpretation of ARRA under the Dynamic General Equilibrium (DGE) model and the Dornbusch–Kalecki (DK) model, focusing on their implications for output, employment, consumption, investment, and external balance.
ARRA under the DGE Framework
Within the DGE framework, an increase in government spending leads to a short-run rise in aggregate demand and output. Firms respond to higher demand by increasing production and hiring more labour, resulting in higher employment levels. However, the magnitude of this expansion is moderated by several mechanisms inherent in the model.
First, consumption may not increase significantly due to the assumption of forward-looking households. Under the concept of Ricardian equivalence, households anticipate future tax increases required to finance government spending and adjust their consumption accordingly. As a result, private consumption may remain stable or increase only marginally.
Second, increased government borrowing tends to raise interest rates, which discourages private investment. This crowding-out effect reduces the overall effectiveness of fiscal stimulus. In an open economy, higher interest rates may attract foreign capital inflows, leading to currency appreciation and a deterioration in the current account balance.
These outcomes are driven by key DGE assumptions, including intertemporal optimisation, rational expectations, flexible prices, and market clearing. While these features ensure internal consistency, they may limit the model’s ability to capture real-world frictions during crisis periods.
ARRA under the Dornbusch–Kalecki Model
In contrast, the DK model predicts stronger and more sustained expansionary effects from fiscal stimulus. Government spending increases aggregate demand through the Keynesian multiplier, leading to higher output, employment, and income.
Unlike the DGE framework, the DK model assumes that households base consumption primarily on current disposable income rather than future expectations. This results in a more pronounced increase in consumption following fiscal expansion. Additionally, higher demand improves capacity utilisation and profit expectations, which can stimulate private investment rather than crowd it out.
Although increased income may lead to higher imports and a deterioration in the current account, this is viewed as a consequence of demand expansion rather than financial market dynamics. The DK framework emphasises demand-led growth, partial capacity utilisation, and stock-flow consistency across sectors, providing a more realistic representation of short-run economic adjustments.
Comparative Evaluation
The DGE model offers strong microfoundations and theoretical consistency, making it suitable for long-term policy analysis. However, its reliance on representative agents, rational expectations, and rapid market adjustments reduces its realism during economic crises. It may underestimate the effectiveness of fiscal policy in the short run.
Conversely, the DK model provides a more realistic account of short-run dynamics, particularly in the presence of demand constraints, financial frictions, and income distribution effects. It captures the potential for fiscal policy to generate significant multiplier effects. However, its lack of rigorous microfoundations and tendency to overestimate fiscal impacts limit its applicability for long-term analysis.
Conclusion
The ARRA can be interpreted differently depending on the analytical framework used. The DGE model suggests limited and potentially offset fiscal effects due to forward-looking behaviour and crowding-out mechanisms. In contrast, the DK model highlights strong expansionary outcomes driven by demand and income effects. A combined approach that integrates the strengths of both frameworks provides a more comprehensive understanding of fiscal stimulus, capturing both short-run dynamics and long-term structural considerations.