Thursday, January 9, 2014

Lewis-Wren on Fiscal Policy

Simon Wren-Lewis says that he is puzzled by the debate regarding monetary and fiscal policy.

In his view, "Macroeconomics" suggests that policy makers should be advised to use both fiscal and monetary policy at the zero nominal bound.   While lowering the policy interest rate is superior to fiscal policy to increase demand, once the policy interest rate is at zero, all that is left is unconventional monetary policy or fiscal policy.  "Macroeconomics" is uncertain regarding unconventional monetary policy.  But Macroeconomics is certain about the effectiveness of fiscal policy.   And so, both should be used.

The "policy makers" should use their discretion to build a mix of fiscal and unconventional monetary policy to expand demand.

My view is different.

I believe that the monetary authority should be given full responsibility for the nominal anchor and held accountable.    Its job is to adjust the quantity of money to the demand to hold it subject to the constraint that spending on output remain on a stable growth path.

The monetary authority controls the quantity of base money and that is enough--unless the demand for base money is greater than the total quantity of assets it is legally permitted to buy.   If the monetary authority buys up everything it can, and the interest rate on reserve balances is less than zero, and currency withdraws are occurring because it is cheaper to store currency than pay to keep money in banks, then fiscal policy might be the least bad option.  We are not in that state now.

Why would fiscal policy help in that situation?   Most obviously, budget deficits generate more assets for the monetary authority to buy.    Another option that should be considered is expanding the assets the monetary authority can purchase.   Or responding to currency withdrawals with a suspension.

The monetary authority has no control over taxes or government spending.    It is inevitable that legislators will have divergent views about what taxes to cut and what kinds of spending to increase.   Those that lose the political battle will complain about deficits and debt.    From their perspective, cutting the wrong taxes or increasing the wrong spending is not worth the deficits and added debt.

In my view, "fiscal policy" is quite properly about the proper allocation of real output between the provision of private and public goods.   That voters face a tax cost for public expenditures is a good thing.   It helps them make a reasonable decision between the benefits of the public goods they hope to receive and the private goods they must sacrifice to pay taxes.    In other words, "fiscal policy" should be about the composition of spending on output, not total demand.

What I favor regarding "fiscal policy" is lower taxes and less government spending.   I favor cutting government spending more than taxes, generating a modest budget surplus and so a gradual paying down of the national debt.    I don't favor such a policy as a means to  raise nominal GDP.  I don't think it would have much effect on nominal GDP.

But I do favor a Reagan/Volcker nominal recovery and then slow steady growth of  spending on output afterwards.     How can that be accomplished?   By having the monetary authority target a growth path for nominal GDP.

Obviously, promoting temporary increases in government spending does nothing to promote my preferred fiscal policy.   I don't see temporary tax cuts as much better.

But I also think that suggesting fiscal policy makes desirable monetary reform less likely.   It provides an out for central bankers who want to continue with business as  usual.

The Fed and other central banks have always preferred to manipulate short term interest rates.    The notion that the legislature needs to change fiscal policy enough so that a central bank can keep policy interest rates in a range they find comfortable is encouraging central bank malpractice

Still further, inflation targeting has proven to be a mistake.    Recoveries from demand short falls have been very slow since inflation targeting gained favor.   While a slow recovery from a mild recession is not a good thing, the slow recovery from the deep recession of 2008 to 2009 has been a disaster.

I see Wren-Lewis as sharing the view of the central bankers.   Continue with business as usual as much as possible.   If it fails, it is the economy's fault.   Let the legislature increase spending or cut taxes enough so that central bankers can stay within their comfort zones.

I was also troubled by Wren-Lewis' statement that both monetary policy and fiscal policy work in a similar fashion--to expand demand by shifting expenditures from the future to the present.    I think he takes new Keynesian models much too seriously.

My view is that a good monetary  regime adjusts the quantity of money to the demand to hold money.   This avoids the disruption caused by monetary disequilibrium and is necessary to maintain the nominal anchor.    Adjusting the quantity of money to the demand to hold it has no necessary implications for shifting spending on output from future to present.   

However, monetary policy is also the lever that maintains the nominal anchor.   If the economy breaks away from its nominal anchor, the monetary regime must generate monetary disequilibrium to bring it back to its moorings.   That also has no implication for shifting spending from future to present.

Why does Wren-Lewis make this statement?   Because he is identifying monetary policy with changes in a policy interest rate.    He is most certainly reasoning from a price change.   A lower interest rate reduces saving and increases consumption now.   But the reduced saving implies less consumption in the future.   There is a shift in consumption from the future to the present.   The way monetary policy increases demand is by lowering the policy interest rate so that consumption rises now, which implies it falls in the future.

My view is that interest rates coordinate saving and investment.   If there is an increase in the supply of saving, that implies a plan to decrease consumption now and increase it in the future.   The reduction in the interest rate tends to decrease the quantity of saving supplied, which implies more consumption now.    However, there is also an increase in the quantity of investment demanded.   In the new equilibrium, there is reduction in current consumption and an increase in current investment.

I don't see this as a shift in spending from the future to the present.    The change in the quantity of saving supplied in response to the lower interest rate is just one part of the process.   And even if investment demand were perfectly inelastic, the "purpose" of the lower interest rate isn't to move consumption from the future to the present, but rather to maintain current consumption.   But better yet, the "purpose" of the lower interest rate is to coordinate the decisions of individual savers so that total saving equals the amount invested.

Suppose there is a decrease in investment demand.   The lower interest rate decreases the quantity of saving supplied which implies a shift of consumption from the future to the present.   There is also an increase in the quantity of investment demanded.   In the new equilibrium, there is less saving, more consumption, and less investment.   This comes much closer to what Wren-Lewis suggested.   But this isn't due to monetary policy, but rather due to the decrease in investment demand.

Put those two shifts together.   The supply of saving rises and the demand for investment falls.   The interest rate falls enough so that the quantity of saving supplied and quantity of investment demanded are again equal.     The amount saved and invested could stay the same, increase, or decrease.   Was the purpose of a lower interest rate to shift consumption to the present from the future?   No, it was to coordinate saving and investment with no particular implication about consumption now and in the future.

In my view, it is certainly possible for a central bank to shift the quantity of money to manipulate interest rates.   And even if a central bank holds the quantity of money constant, it is very possible for changes in interest rates to impact the demand to hold money.   The resulting monetary disequilibrium can easily interfere with the market adjustment in interest rates needed to coordinate saving and investment.

For example, suppose the supply of saving increases, the demand for investment decreases, and the demand to hold money rises.    The central bank raises the quantity of money just enough to prevent any liquidity effect that would raise interest rates.   At the market interest rate, saving is more than investment.   The amount invested falls as does consumption spending.

Now, let's suppose that the central bank expands the quantity of base money enough to meet the demand for money, allowing market interest rates to fall to a level so investment and saving are again equal.   Investment and consumption spending both rise.   Was the purpose of relieving the monetary disequilibrium to shift consumption from the future to the present?   No, the result might be a shift of consumption from the present to the future or no shift at all.   The point was to relieve the monetary disequilibrium and allow the market interest rate to adjust enough to coordinate saving and investment.

Finally, suppose the reason that saving increased and investment decreased is because spending on output has fallen to a lower growth path.   Money wages are much too high, and while the growth of wages has slowed, and should eventually converge with the new equilibrium growth path for wages, the process is slow.   Real output and employment are depressed.

If the central bank commits to getting nominal GDP back to the previous growth path, saving will fall and investment will rise.   The interest rate needed to coordinate saving and investment will rise.   Is the purpose of this commitment to raise nominal GDP to shift spending from the future to the present.   No.    The propose is to increase spending in the future and the present.


  1. Assume the Federal government decides today to borrow $1 trillion and spend it in the next 12 months on roads, bridges and other infrastructure and on giving money to the states to hire teachers, police and related facilities. Assume all other policy remains the same, including announced monetary policy.

    What do you believe would happen to GDP (real and nominal), employment, inflation and any other such aggregate you consider relevant?

    1. If the target for the growth path of nominal GDP stayed the same, there would be a modest increase in the growth path of the price level and real output. Very little impact on the growth path of employment. Some run down in inventories.

      Did you mean some other kind of monetary policy, like holding a policy interest rate or the growth path of base money constant?

  2. The benefits of an NGDPLT are visible in 'history':

  3. I agree that an optimal policy is to maintain a steady growth path for NGDP by adjusting the quantity of money based upon future NGDP expectations.
    At the ZLB the authorities have 2 choices: Monetary or Fiscal policy. I disagree with your view that monetary policy trumps fiscal policy. Here’s why.
    Fiscal policy works by adjusting the govt deficit. This increases income which increases expenditure and (hopefully) increases RGDP. This can be done (via helicopter-drop style activities) with no direct govt expenditure on goods at all. The effect is very direct and if done within an NGDP-targeting framework not likely to be affected by Ricardian equivalence.

    Monetary policy work at the ZLB by a much more roundabout way. The CB swaps money for other financial assets. This new money will be used to purchase other assets (driving up their price) and eventually as people’s nominal wealth increases they will start to increase expenditure on final goods (which will then lead to an increase in RGDP just as with fiscal policy).

    I can see a number of reasons why the fiscal approach may be a better way of increasing NGDP. Here’s why:

    1. Other things being equal (and using reasonable assumptions) the base will have to increase much more under monetary policy than under fiscal policy to achieve a given NGDP target at the ZLB. The increase in the base will drive up asset prices and reduce the return on these assets. These asset-bubbles and lower interest rates on risky ventures (over and above the zero interest rates on risk-free assets) may have negative effects on the economy.
    2. Very much related to point 1 is the fact that under fiscal policy it is possible for the authorities to target interest rates as well as a given level of NGDP. They can do this by using the deficit to control NGDP and using bond purchases to maintain a given positive interest rates. This means that they can keep interest rates close to the (estimated) natural rate better than with monetary policy alone.
    3. Monetary policy benefits people who hold assets more than tgoise who don’t (and the more assets you have the more you benefit). The reason for this is that most of the additional expenditure is due to the “wealth effect” of increased asset prices.
    I think that fears that using fiscal policy to target NGDP will lead to dangerous govt deficits are misplaced. If deficits are used only to address shortfalls in private expenditure that would otherwise lead to recession then I do not see why this would be problem (they would be balanced out by govt surpluses when private expenditure would otherwise increase NGDP beyond target.