Fiscal Policy Multipliers

Ummm... No. This is not good:

Greg Mankiw's Blog: Monetary vs Fiscal Policy: [M]uch of the short-run stimulus effect of fiscal policy comes about because it induces a monetary expansion. This monetary expansion is automatic if the Fed is holding the interest rate fixed or if it is following something like a Taylor rule, which is approximately what it is doing now. The effects of fiscal policy would be very different if the Fed were holding the money supply constant in response to a fiscal change.... One way to answer this question is to look at the fiscal-policy multiplier. In chapter 11 of my intermediate macro text, I give the government-purchases multiplier from one mainstream econometric model. If the nominal interest rate is held constant, the multiplier is 1.93. If the money supply is held constant, the multiplier is 0.60. If the LM curve were completely vertical, the second number would be zero...

The Federal Reserve today does not react to a fiscal expansion by increasing the money stock. The Federal Reserve today reacts to a fiscal expansion by raising interest rates and contracting liquidity so as to try to still hit its inflation target. As Larry Meyer said once, "if you don't know that the Fed has been targeting a 2% CPI inflation rate, you simploy haven't been paying attention."

These days, except in exceptional circumstances--in a liquidity trap, when interest rates are already so low that the Fed can't or daren't lower them further, or when the fiscal expansion comes as a sudden surprise that the Fed does not have time to immediately offset--fiscal policy has next to no stimulative effect at all because the Federal Reserve takes steps to make sure that it does not. That's the big reason that claims in 1993 that the Clinton tax increases were going to send the economy into recession were wrong.

We do our students no good service if we teach them that in today's economy, in normal times outside of a liquidity trap, expansionary fiscal policy "creates jobs" in even a temporary and ephemeral sense.

---

UPDATE: Greg Mankiw writes:

It might be worth pointing out to your readers that the example I was discussing, raised by the question from Bryan Caplan, was the WWII fiscal expansion. Maybe you guys think the Fed was targeting Y at Y* back then, but I doubt it.

The only thing I said about the current situation is that the Fed is following something like a Taylor rule. This is hardly a radical idea: it dates back to Taylor himself.

Comments

[Jeffrey Miller]

I think Prof. Mankiw has made a slight error. The multiplier should really be 1.94, not 1.93.

"...for it is the mark of an educated man to look for precision in each class of things just so far as the nature of the subject admits" - Nicomachean Ethics

[slink]

there seems to be
a pretty steady stream
of snake oil coming out of the back
of doc mankiw's painted wagon these days

bright he may well be
but so we're led to believe
was
lysenko

[bakho]

Has Bush fiscal policy proved that it is how the deficit is spent, not deficit spending by itself that affects "job creation"? Is a single multiplier a gross over-simplification?

[meno]

Uh,

My brain hurts. I almost followed that, but not quite.

My (very) small understanding of Keynesian economics says that govt surplusses reduce the amount of money and cools the economy, and govt deficits vice versa.

Looking at a nation where the Central Bank is targetting inflation in a 1%-to-3% range, are you telling me that this simple Keynesian story is no longer true?

[alhs77st]

Meno,

I think what Professor DeLong is saying is that the Fed will do whatever it takes to keep inflation at about 2%. Thus, if the government increases its spending, the Fed will immediately increase interest rates, so that there will be no net increase in aggregate demand.

[jerry]

I was pretty crappy in macro, but earlier today (at drums? here? matt's?) I argued that Bush's legacy was proving Keynes' wrong. He added 3T to the debt and increased the economy and jobs not one whit. And I even said, this really didn't prove Keynes' wrong as he didn't spend any money, he just added debt and gave the money away.

[Brian]

Exactly what is "expansionary fiscal policy" good for, then?

[Barkley Rosser]

Brad,

We had stimulative fiscal policy, very stimulative fiscal policy for a good three years or so under Bush before the Fed began to raise interest rates starting in mid-2004. What are you talking about?

I know that I am old fashioned, but a fiscal multiplier of about 2 (1.93 or 1.94 is about there) is still a pretty good back of the envelope guesstimate. Of course it is useful to remember that the spending one is bigger than the tax change one, part of the explanation for why Clinton's tax increase was not so damaging (plus Greenspan did keep his side of the bargain and ran stimulative monetary policy then).

When there are spending increases, the first round of the multiplier effect usually shows up in the local areas where the spending occurs. It is not just the direct effect of pork barrel spending that makes it so effective to politicians. I am more aware of this than most macroeconomists who have been seduced by all this ratex drivel because I also study urban and regional economics. Those multiplier really are there.

[walkingtheline]

jerry,

Keynes theory involves assumptions of ceteris paribus. By raising and lowering interest rates, the Federal Reserve influences the amount of borrowing, thereby increasing or decreasing the amount of money in circulation.

I think Brad is over-reaching a bit since if you have a cautious or politcally pliable Federal Reserve you will see short-term effects. But point taken. Mankiw should not be pretending that the Federal Reserve doesn't exist.

[Jack]

To argue that holding rates means that the fed wasn't taking action you also have to show that the fed would not otherwise have cut rates. Holding rates can be a tightening as much as a hike.

Also if the tax cuts were not stimulative in the first place because they were targetted at those who are so rich that extra cash makes very little difference to their behaviour there wouldn't have been a stimulative effect for the Fed to respond to.

That of course is a more contentious argument but it is possible that Bush economic policy might have more than one problem.

[christo]

"When there are spending increases, the first round of the multiplier effect usually shows up in the local areas where the spending occurs"

And that's why Dirk Cheney was able to afford that $6 million home in Maryland.

[anne]

Brad DeLong:

'The Federal Reserve today does not react to a fiscal expansion by increasing the money stock. The Federal Reserve today reacts to a fiscal expansion by raising interest rates and contracting liquidity so as to try to still hit its inflation target. As Larry Meyer said once, "if you don't know that the Fed has been targeting a 2% CPI inflation rate, you simply haven't been paying attention."'

Precisely.

[meno]

"I think what Professor DeLong is saying is that the Fed will do whatever it takes to keep inflation at about 2%"

Okay, I've thought about this, and my naive response is:

Ben Bernanke Is Not God

Maybe I need to find a good textbook on the US economy. Isn't the Fed just fiddling the bank's reserves? But doesn't that just leave them holding on to one end of the interest rate curve - the overnight rate? That's fine if that curve is solid bar - move one end up and down and the whole thing moves. But it isn't. The increasingly global nature of capital (OTC financial derivatives are now worth about $10 trillion globally) means that they're holding one end of a piece of string - and the string is slacker every year.

Nope, I still don't get it.

[anne]

Inflation through the last 12 months is 2.4%, which given the continuing energy price increase and well growing economy is remarkable and promising. There is no reason to believe the Federal Reserve will not be able to readily limit inflation from here.

[pgl]

Your post reminds me of a William Poole QJE paper published back in 1970. I'm sure Greg has read it. Incidentally - if the FED kept the money supply constant and if the LM curve is not vertical (Greg's assumption) the fiscal multiplier could still be zero in a world of floating exchange rates if capital mobility is infinite. Something Mundell wrote about 40 years ago. I'm sure Greg is familiar with Mundell's musings.

[anne]

http://economistsview.typepad.com/economistsview/2006/06/paul_krugman_th_1.html#comments

June 16, 2006

Paul Krugman wonders why the Fed is so concerned with inflation when wage growth isn't keeping up with productivity:

The Phantom Menace, by Paul Krugman, Commentary, NY Times: Over the last few weeks monetary officials have sounded increasingly worried about rising prices. On Wednesday, Richard Fisher, the president of the Federal Reserve Bank of Dallas, declared that inflation "is running at a rate that is just too corrosive to be accepted by a virtuous central banker."

I'm worried too — but not about recent price increases. What worries me, instead, is the Fed's overreaction to those increases... Discussions of inflation can be numbingly arcane — are you a core C.P.I. type or a trimmed-mean P.C.E. person? But the real issue is whether there's a serious risk that inflation will become embedded in the economy.

The classic example of embedded inflation is the wage-price spiral — better described as wage-price leapfrogging — of the 1970's. Back then, whenever wage contracts came up for renewal, workers demanded big raises, both to catch up with past inflation and to offset expected future inflation. And whenever companies changed their prices, they raised them by a lot, both to catch up with past wage increases and to offset expected future increases.

The result of this leapfrogging process was that inflation became a self-sustaining process, feeding on itself. And ending that self-sustaining process proved very difficult. The Fed eventually brought the inflation of the 1970's under control, but only by raising interest rates so high that in the early 1980's the U.S. economy suffered its worst slump since the Great Depression.

Fed officials now seem worried that we may be seeing the start of another round of self-sustaining inflation. But is that a realistic fear? Only if you think we can have a wage-price spiral without, you know, the wages part.

The point is that wage increases can be a major driver of inflation only if workers consistently receive raises that substantially exceed productivity growth. And that just hasn't been happening. In fact, the distinctive feature of the current economic expansion — the reason most Americans are unhappy with the state of the economy... is the disconnect between rising worker productivity and stagnant wages...

Nor is there much sign that things are changing on that front. ... But if wage pressures are so moderate, where's the inflation coming from? The answer is soaring oil and commodity prices.

It's true that some widely used inflation measures, like so-called core inflation, strip out the direct "first-round" effects of rising energy prices. But there are still indirect effects, which usually take some time to show up in the data. Much of the recent rise in core inflation probably represents the delayed effect of the big run-up in fuel prices a few months ago. And unless something else happens to drive up oil prices — like, to give a wild example, a military strike on Iran — inflation will probably subside in the months ahead. ...

It would be an exaggeration to say that there's no inflation threat at all. I can think of ways in which inflation could become a problem. But it's much easier to think of ways in which the Federal Reserve, wrongly focused on the phantom menace of a new wage-price spiral, could be slow to respond to bigger threats, like a rapidly deflating housing bubble.

So I don't fear inflation nearly as much as I fear the fear of inflation. And I wish the Fed would lighten up on the subject.

[anne]

http://economistsview.typepad.com/economistsview/2006/06/paul_krugman_th_1.html#comments

June 16, 2006

Robert Reich joins the chorus of voices wondering if the Fed is overreacting to the threat of inflation:

There's No "Inflation Genie.", by Robert Reich: I've spent much of the day on the phone, talking with financial reporters about inflation and the "consensus" view on Wall Street that Bernanke and the Fed must raise short-term rates again in order to stop the inflation genie from getting out of the bottle. Wall Street is wrong. It's still haunted by the double-digit inflation of the late 1970s. It forgets the double-digit depression of the 1930s.

The fact is, this economy is not at all like the economy of the 1970s. Labor unions don't have nearly the power they did then to demand wage increases. Big companies don't have nearly the power they did then to raise prices. Globalization and computer software have radically increased wage and price competition. So the inflation genie won't get out of the bottle. The price rises we're seeing now are due to energy and raw-material commodity price increases, which are NOT being driven by excessive demand by American consumers and NOT being driven by inflationary expectations. ...

In addition, productivity has grown enormously in the US during the last five years. Wages have not. Wages comprise 70 percent of the costs of business. One last thing: There's still lots of unemployment in the US. The payroll survey shows only small increases in hiring. A smaller proportion of adults are employed now than in 2000. The ranks of people too discouraged to look for work are very large.

So forget the inflation genie. Worry more about the 1930s. I don't mean to suggest a full-fledged depression is on the horizon. But I do worry that the economy is slowing. Consumers are reaching the limit of their capacity to go deeper into debt. Their one cash cow -- the value of their homes -- is in poor shape. ... If the Fed keeps raising short-term rates we're heading for a major downturn.

Me thinks Bernanke wants to show Wall Street he's a tough guy. But tough guys often over-estimate the importance of acting tough.

In the end, the people who get clobbered when the Fed raises rates and the economy slows are those at the end of the job line -- people who need jobs, or are in low-paying ones. They're the first to be let go. At a time when the number of working poor in America are already ballooning, and the ranks of the impoverished are growing, it's not only economically wrong for the Fed to go on raising rates. It's ethically wrong.

[Maynard]

Brad, your criticism makes perfect sense if you assume the economy is at full employment when the expansionary fiscal policy action occurs. But if the economy starts in a position below full employment the fiscal multiplier comes into play. The Fed can maintain a constant interest rate policy without violating its commitment to its inflation target.

It is not necessary for the economy to be in a liquidity trap for the fiscal multipliers to be operative. Apparently (e.g. judging from the sluggishness of the recovery in the U.S. from 2001-present) the economy's self-adjustment mechanisms are slow enough that the economy can remain below full employment for some time even if it is not in a liquidity trap.

It's evidence of a real flaw in our training as macroeconomists that we reflexively do all our comparative statics exercises from a basis of full employment equilibrium, even when that is not appropriate. Everyone needs to go back and re-read the General Theory.

[bakho]

It seems that all the "No inflation" discussion is a warning not to repeat the Fed mistake of the late 1990s.

[knzn]

Maynard, The problem with your argument: Assuming we’re not in a liquidity trap, if the Fed wanted more economic stimulus, the Fed would already be providing that stimulus. Even if we’re below full employment, the Fed will not want to approach full employment too quickly (in part because of dynamic effects, and in part because it’s not sure where full employment is), so it will offset any increase in fiscal stimulus with a reduction in monetary stimulus. In 2003, however, the economy arguably was in a liquidity trap, so fiscal policy had an effect. In 1993, we were clearly not in a liquidity trap, but we were certainly below full employment, yet fiscal policy had no effect.

[BILL]

I remember when the Bush tax cuts were being proposed and discussed, Paul Krugman wrote a number of pieces saying that the design of the tax cuts would provide the minimal boost and described others that would provide bigger bang for the buck. Paul's pieces made sense to me. Brad's argument makes sense to me. But they can't both be true. Oh well.

[kharris]

Brian,

There is a policy notion that one ought to address problems as directly as possible, because taking action that addresses them indirectly allows for leakage. The further in the chain of exchanges you get from your actual target, the more of the policy effort that will wander off. If slack demand is the problem, the most direct way to address it is for the government to spend money on goods and services. Direct purchase of goods and services is demand itself, not a "stimulus to demand" as tax cuts or rate cuts would be. (See the reference above to the bigger multiplier for spending than taxes.) Even so, the Ur-Keynesian (J.M.) was of the view that fiscal policy was a tool of last resort, to be used at such time as monetary policy was ineffective. Automatic stabilizers came later, but they, too, can serve a function. Monetary policy needs to do less when automatic stabilizers are in place, which is what is behind some of the comments here, as well.

Meno,

Maybe "fiberglass rod" is a better metaphor. As the Fed pushes, the rod bends at shorter maturities, and may move at longer maturities. Ten year rates are not the alpha and omega of the credit market. Lots of people borrow at shorter maturities. We should also not think only in terms of Treasury rates. Corporate and mortgage yield curves have been flatter than normal, but have not been dead flat or inverted. The Fed has some leverage at longer maturities for borrowers other than the Federal government. Liquidity also has other conduits than the Treasury market. Stock and commodity market responses to the possibility of more rate hikes has been fairly pronounced.

[anne]

"I remember when the Bush tax cuts were being proposed and discussed, Paul Krugman wrote a number of pieces saying that the design of the tax cuts would provide the minimal boost and described others that would provide bigger bang for the buck. Paul's pieces made sense to me. Brad's argument makes sense to me."

The arguments were identical at the time when we were coming from a recession and the Federal Reserve was keeping short term rates especially low. Recovery and rising energy costs have led to a long series of Fed tightenings further limiting the effect of the latest tax increases beyond the structure of the increases.

[Barkley Rosser]

pql,

The Poole and Mundell pieces assume forex markets that are well-behaved. They are not. There certainly is a problem with defining what "ceteris paribus" means with regard to monetary policy, but Brad certainly overdoes it in describing in assuming that Ben Bernanke is somehow going to offset any fiscal stimulus because of his public commitment to a 2% inflation target.

Presumably if inflation is well below 2% (which is not now), he would not offset fiscal stimulus, and was on the Fed Board when they did not do so after 2001. Indeed, his inflation targeting then got him tagged as an "inflation dove" by some. Remember all that helicopter money talk?

I will grant that my urban/regional perspective does not absolutely make the case. So, it may be that the Fed is offsetting in the aggregate a fiscal stimulus, but there could still be a local stimulus from a spending increase, with relevant local multipliers operating (and helping Dick Cheney and other mil-ind complex fatcats) get rich. But those might be offset in the aggregage by declines elsewhere in the economy, hence on net a redistribution to the areas where spending occurs away from areas where it does not.

[anne]

http://economistsview.typepad.com/

June 16, 2006

Crowding Out
By Mark Thoma

Greg Mankiw and Brad DeLong are discussing crowding out. Paul Krugman, via email, weighs in on the debate. I turned it into a Q&A and added some graphs to illustrate Paul's points:

Is the IS-LM model still a useful theoretical device?:

Think of a standard IS-LM picture. Does that match current reality? Obviously not: the Fed doesn't target the money supply, so holding M constant is not a useful thought experiment, and actually confuses students. In fact, since the Fed actually targets the Fed funds rate rather than the money supply, you might think that the LM curve should be replaced with a horizontal FF curve. This would seem to suggest no crowding out at all.

Is there a better way to represent policy?

In the very short run the Fed doesn't set the interest rate passively; instead, it tries to stabilize output around potential. A reasonable way to represent a Taylor rule or something like that in a simple diagram is to draw a *vertical* line, the BB curve (for Ben Bernanke). This gives us 100% crowding out.

Are you sure? Are there any exceptions?

I think that's right. Except in liquidity-trap conditions or in the very short run, before the Fed has a chance to catch up, fiscal policy doesn't change aggregate demand, only the mix. The exceptions are important: we had a near-liquidity trap experience in 2003, and it was a good thing that we had some fiscal stimulus (and a bad thing that the stimulus was so poorly designed). But the normal rule is that fiscal policy is fully crowded out.

For those who like graphs:

....

Under the standard IS-LM model assumptions, a change in fiscal policy that increases government spending or cuts taxes would shift the IS out and output would move from Y* to Y''. It is useful to break the movement into two parts. The movement from Y* to Y'' is the output change predicted by the simple expenditure multiplier and the change from Y'' back to Y' is crowding out. It occurs due to rising interest rates.

Greg Mankiw modeled the Fed as keeping the interest rate fixed at i* in which case the Fed should increase the money supply as shown in the next graph to keep the interest rate fixed at i*. Notice that output will rise more than if the interest rate is allowed to increase to i', and at Y'' there is no crowding out.

....

Krugman is saying this is not how the Fed operates in the short-run. Instead, the Fed moves to stabilize output at Y* so that the LM curve shifts back, not out, and output remains at Y*. In this case, crowding out is 100%:

....

This is the basis for DeLong's statement that:

The Federal Reserve today does not react to a fiscal expansion by increasing the money stock. The Federal Reserve today reacts to a fiscal expansion by raising interest rates...

[Graphs as referenced by Mark Thoma.]

[bakho]

So if all attempts at fiscal stimulus will be counteracted by monetary policy, why not run a balanced budget or a slight surplus? Won't the Fed keep interest rates lower because of the reduced buying power from the higher taxes is less inflationary?

[andres]

"We do our students no good service if we teach them that in today's economy, in normal times outside of a liquidity trap, expansionary fiscal policy "creates jobs" in even a temporary and ephemeral sense."

This is incorrect, Brad, insofar as it is unlikely that "normal times" apply, even if the economy seems to be doing nicely, so that the Fed's policy stance is wrongheaded. The starting point of the counter argument is from Maynard (Keynes?):

"But if the economy starts in a position below full employment the fiscal multiplier comes into play. The Fed can maintain a constant interest rate policy without violating its commitment to its inflation target."

But this is only a starting point. Fiscal expansion does not have to create inflationary pressure; it doesn't even have to create expansionary output pressure if it is targeted so that it has what I like to call quasi-Ricardian equivalency effects.

The idea is that fiscal expansion mostly increases saving rather than consumption, but not because the public is farseeing enough to see the day long in the future that the government engages in resulting fiscal contraction, but rather because the predominantly middle-class public is deeply desirous of improving its net wealth position, especially by reducing its debt burden.

The current situation is that a larger proportion of US families is becoming dangerously overextended financially, and that it will take only a brief foray into recession territory to push many such families into bankruptcy, creating negative multiplier effects. Because the idiot-stimulus package proposed by the Republican leadership has left the middle-class completely behind, it has done nothing to reduce the growing financial fragility of the US economy.

A fiscal restructuring that is correctly targeted, e.g. by giving much larger subsidies or tax rebates for debt reduction payments on mortgages, student loans, credit cards and so forth, can help reduce growing financial vulnerability. This restructuring doesn't even have to be expansionary, as it can be more than counterbalanced by repealing the upper 1%-targeted taxcuts of the current crony capitalist administration. But _somebody_ has to mention the long-term financial effects of fiscal policy, and that fiscal policy can be used to increase consumption in the future even if it doesn't increase consumption (and therefore inflation) today.

[wml]

I've only had basic macro - I asked once why we use fiscal policy at all - why not just use monatary policy to regulate inflation/employment. My instinct was there was something unseemly about ever using fiscal policy: just pick a optimal tax and spending rates and stick with them. Don't mess up the real economy by fiddling with taxes and spending just to try to fight the voodoo of inflation.

I was given two answers:

1. Exchange rates. Stable exchange rates require a mix of fiscal and monitary policy. Furthermore, if Congress doesn't cooperate, the Fed might choose to miss it's inflation targets slightly in order to hit it's exchange rate targets more closely. I was taught fed also cares about exchange rates.

2. Error fudging. As an example, suppose you need to expand the economy by one unit. You can either use fiscal policy, which will expand the economy by 1 + epsilon, or you can monatary policy, which will expand the economy by 1 + mu, or a policy of half and half, which will expand the economy by 1 + epsilon/2 + mu/2. If the variance of epsilon and mu are the same, expected value of epsilon and mu are zero, and epsilon and mu are independent, then the mixed policy will have lower variance, and so is more likely to be accurate. The mix might also lend itself to more bold actions, if error rates increase with more radical corrections or there is an asymetric loss function for missing inflation target.

Either of those reasons could make it so mixed fiscal/monetary policy will more successfully create jobs by pushing closing to full employment relative to monetary policy alone.

I have no idea if these arguments are valid in practice, however. I'm just reporting what I was told. Did my macro professor do me a disservice?

[anne]

Alan Greenspan made it clear for years that the exchange rate is a minimal concern of the Federal Reserve. The dollar goes up and the dollar goes now, and somehow someway we go on though who know what might happen to the price of Franch cheese (shudder). As for fudging errors, please. There is fiscal policy because there is a Congress and needs and hopes and even fears to address by Congress, while the Federal Reserve is no Congress :)

[William Chiu]

Dear Professor Delong,

You made two assumptions to support your conclusion that expansionary fiscal policy does not usually create jobs in the short run.

First Assumption: The Fed has a strict inflation target.

Second Assumption: Monetary policy has an immediate effect on aggregate demand.

I have several objections to these assumptions.

1. The Taylor Rule has two explanatory variables the inflation gap and the unemployment gap. Even if the Fed targets 2% inflation in the long run, it might accomodate expansionary fiscal policy in the short run if the economy was in a recession. Hence the Fed might allow a little bit more inflation in order to reduce the unemployment rate.

2. If we assume that inflation is "sticky" in the short run and the Fed cares only about current inflation, then there is no reason for the Fed to raise rates after an expansionary fiscal policy because (in the short run) the fiscal policy has NO EFFECT ON INFLATION.

3. Even if the Fed raises rates immediately after an expansionary fiscal policy, monetary policy takes time to affect aggregate demand (as much as 6 months). Hence during those six months, the expansionary fiscal policy via the multiplier process might lower the unemployment rate!

In a world of static or adaptive expectations, expansionary fiscal policy plays are large role in creating jobs (at the very least in the short run).

Viva Keynes.

William Chiu

[2slugbaits]

KNZN,

You said to Maynard:

"The problem with your argument: Assuming we’re not in a liquidity trap, if the Fed wanted more economic stimulus, the Fed would already be providing that stimulus."

Three points. First, the Fed's reaction to fiscal stimulus is likely to be incremental and there could be a significant lag before the rate changes catch up with the fiscal stimulus and any output gaps. Granted, in principle the Fed could react more aggressively, but the public has come to expect small 25 basis point movements. Second, there's that old problem of pushing on a string. It's fairly easy for the Fed to shrink the economy, but using monetary policy to stimulate demand is a dicier proposition. Finally, the Fed is not omniscient. Even St. Alan was known to get it wrong from time to time.

And speaking of St. Alan, apparently even he did not believe the Fed could fully counter fiscal policy. As I recall Greenspan was quite worried about the contractionary fiscal effects of a sustained budget surplus. This suggests that even Greenspan did not fully believe the Fed could completely neutralize fiscal policy.

It seems to me that although Brad has a point, he is overreacting. Mankiw was only trying to make a pedagological point. Yes, he probably should have pointed out that in the real world the Fed often inserts itself into the process and things are not always ceteris paribus. But by the same token Brad should also admit that sometimes the Fed reacts the wrong way as well...I'm thinking of Bill Miller and Arthur Burns.

[Jack]

Mankiw's argument about Taylor rules seems odd. As I understood it the coefficients in a Taylor rule are only constant Ceteris Paribus and would respond to a change in fiscal environment. It is therefore wrong to think of Taylor rules as being equivalent to an interest rate target. Also aren't Taylor rules empirical rather than actual policy?

Mankiw has to claim that there are two kinds of stimulation -- fiscal and monetary and that they are to a significant extent independent. To the extent that they are the same introducing fiscal stimulus will simply be offset by monetary policy.

The suggestion that fiscal policy might have some effect before monetary policy kicks in seems wrong in two respects. Firstly fiscal policy is much less wieldy than interest rate policy and itself takes time to become effective. The fed is likely to see it coming and can adjust much more quickly, even at 25 basis points at a time.

Secondly, it seems to presuppose two authorities on monetary policy acting with little coordination. That could not be healthy. Even if St. Alan or BB is fallible that is no reason to think that second guessers will be less so or that fighting with actual policy actions would be more effective.

It seems to me that Brad is on the button if we are talking about aggregate effects and ctalking about aggregate stimulus but that there are redistributional issues that possibly over the short term and definitely over the long term are critical.

[knzn]

2slugbaits, You’re first point is well taken, though I think you maybe overstate it just a tad. The Fed tends to be conservative in reacting to anything, including fiscal policy, so it might take some time to catch up, and there would be less than 100% crowding out in the short run. I disagree with your other two points, however. Pushing on a string only really becomes an issue if we’re in a liquidity trap; on the way down, the Fed knows that it has to push hard to get a response, and – subject to your first point – it will push as hard as it needs to until it actually reaches a liquidity trap. Regarding your third point, sure, the Fed is not omniscient, but this could just as easily mean they will overreact to fiscal policy, so there could be more than 100% crowding out. To the extent that your third point is just an explanation for why the Fed tends to be conservative, it is a valid adjunct to your first point. As for Greenspan’s statements, I think he was mostly concerned about the possibility of a liquidity trap (and rightly so, since, arguably, one subsequently occurred despite the tax cut). I wouldn’t bring in Bill Miller and Arthur Burns: that’s ancient history; the Fed today knows better than to accommodate fiscal policy deliberately.

[2slugbaits]

KNZN

I suspect Bill Miller and Arthur Burns also knew better but that didn't stop them. If Bush had done what he usually does, (i.e., nominate political hacks for important jobs), then we might very well be back to ancient history. I worry because the Fed seems to be especially vulnerable to a kind of cult of personality and getting a good personality is too contingent for my tastes. Just imagine if a President Cheney had nominated the Fed chair!

As to Greenspan's motives, I just take him at his word here. He was pretty explicit in saying that he thought fiscal multipliers were significant enough that a sustained budget surplus would be a drag on the economy. That leads me to believe that Greenspan was not terribly confident about the Fed's ability to stimulate demand. It could be that he was worried about a liquidity trap, but remember...he made those comments well before the time that NBER dates the economy going into recession. It just seems like a reach. In fact, even Krugman wasn't talking about a liquidity trap until at least a year after Greenspan's testimony.

To the extent that we're talking about stimulating consumer demand (or God forbid, real estate investment), then I would agree that "pushing on a sting" is not a big problem; but I'm less convinced when it comes to stimulating capital investment demand. And the last recession was mainly a slump in non-real estate investment demand. If businesses expect interest rates to be low for a long time, then what's the rush to invest today just because the Fed lowers the Federal Funds Rate by 25 basis points? But then again I've never believed business's sensitivity to the interest rate changes was the same going up the business cycle as it is going down the business cycle.

[Blissex]

Some amusing comments on the interplay of fiscal and monetary policy, under unrealistic assumption (Mankiw's speciality? :->):

"I argued that Bush's legacy was proving Keynes' wrong. He added 3T to the debt and increased the economy and jobs not one whit."

"The increasingly global nature of capital (OTC financial derivatives are now worth about $10 trillion globally) means that they're holding one end of a piece of string - and the string is slacker every year."

"We had stimulative fiscal policy, very stimulative fiscal policy for a good three years or so under Bush before the Fed began to raise interest rates starting in mid-2004. [ ... ] When there are spending increases, the first round of the multiplier effect usually shows up in the local areas where the spending occurs."

Well, my take on this is to point out the obvious:

* In the past decade USA monetary policy has been ultra loose.

* In the past 5 years USA fiscal policy has been ultra loose.

* Usually this leads via investments to large job creation and high inflation.

* In the USA job creation and high inflation have not happened.

* They have however happened in Bangalore and Shanghai.

The ability to raise large amounts of pretty much free capital or to make large amounts of pretty easy profits has indeed led USA companies to an investment led boom, just not in the USA, as these companies have preferred to invest that free capital or easy profits in other countries.

And if one looks at the inflation of prices and wages in Bangalore and Shanghai it is quite obvious that the USA investment boom is having a very large Keynesian effect.

[Blissex]

"As I understood it the coefficients in a Taylor rule are only constant Ceteris Paribus and would respond to a change in fiscal environment."

Oh man, sutble violations of ''ceteris paribus'' is the first and easiest technique in the arsenal of the dissembling economist.

[Jim Harris]

This seems a little unfair to Mankiw (not to in any way defend Administration fiscal policy). He's just saying that you have to allow for whatever accomodations monetary policy makes when thinking about the impact of fiscal policy. Fair enough a thing to remind students of.

As far as whether the central bank targets interest rates or inflation, that has been a subject of much debate and discussion over the years. It's not as though one or the other has always been in evidence to the exclusion of the other and Mankiw is somehow an idiot for not knowing.

[imran]

How the Fiscal and Monetary multiplier affect GDP, employment and Prices?