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Lernerism in a Hicksian Straightjacket

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Whenever I read Abba Lerner (1943) or his latter-day disciples, I find myself puzzled by their near-certainty: they know that fiscal expansion and contraction can keep employment high and inflation equal to expectations, and that monetary expansion can keep interest rates so low that there is no government budget financing constraint that binds.

As with so much else, a remarkably large measure of clarity can be achieved quickly by casting their argument in Hicksian (1937) IS-LM terms.

Why doesn't monetary expansion producing overheated economy and rising inflation, as inflation expectations become dis-anchored? Because there is little sensitivity of spending to the interest rate--the IS curve is steep. Thus even a large overshoot on the inflationary side on monetary policy can be neutralized by a small fiscal contraction.

Why doesn't a monetary expansion raise expectations of future inflation on its own? Why should it? Business executives, financiers, and forecasters know how small are the interest elasticities of spending components. Grant me a steep IS-curve--a low interest elasticity of spending--a central bank that does not care about the nominal value of the exchange rate, and a fiscal authority that can actually raise taxes and cut spending to cool off an inflationary gap, and Lernerian-MMT conclusions follow.

At the zero nominal lower bound, therefore, Lerner-MMT is the way to bet. Demand is not very responsive to monitor policy-driven interest-rate decreases because short-term interest rates cannot decrease. The government's budget is not a binding constraint because financing the government budget deficit is so easy with interest rates so low.

Once we move away from the zero nominal lower bound, however, the adequacy of Lerner-MMT is an empirical issue:

  • How sensitive are the components of spending to the interest rate?
  • How much is present monetary expansion taken as a signal of future inflation?
  • How much are currency-printing sovereigns still bound by a nominal exchange rate target?
  • What are the drawbacks of maintaining interest rates--through money-issue and financial repression--low enough to keep the government's intertemporal budget from being a binding constraint?

To me, at least, these are still open empirical questions. And the answers to these empirical questions can change from decade to decade and from country to country.