Suppose there is a shortfall in aggregate demand associated with a rise in involuntary unemployment in a simple closed economy with no capital. Do we try and raise private consumption (C) or government consumption (G)? If the former, why do we prefer to use monetary policy rather than tax cuts?
If consumers have stable preferences over privately and publicly produced goods, then ideally we want to keep the ratio C/G at its optimal level. So if the aggregate demand gap is caused by a sudden fall in C, we will want to do something to raise C. As real interest rates are the price of current versus future consumption, the obvious first best policy is to set nominal interest rates to achieve the real interest rate that gets C to a value that eliminates the consumption shortfall. That is the basic intuition behind the modern preference to use monetary policy as the stabilisation instrument of choice: part of what I have called the consensus assignment.
In classical or real business cycle models this happens by magic. It normally goes by the term ‘price flexibility’, but it is magic because it is rarely explained how a lack of aggregate demand gets translated into lower real interest rates. In the real world, the magicians are central banks. Note that I have not mentioned anything about implementation lags associated with monetary or fiscal policies, which is one of the reasons you will find in the textbooks for the consensus assignment. My reason for preferring monetary policy is more intrinsic than that.
What happens if the aggregate demand shortfall occurs because ‘supply’ increases through technical progress? Once again the first best policy is to lower interest rates to increase consumption, but we would also want to raise public consumption to keep the optimal C/G ratio.
Finally consider a more difficult shock - a ‘cost-push’ shock to the Phillips curve that raises inflation for a given level of output and aggregate demand. We know that we want policy to reduce output (to create a negative demand gap) to partially reduce inflation, assuming that both the output gap and inflation are costly. However it is less obvious in this case that monetary policy is first best. However, as Fabian Eser, Campbell Leith and I showed in this paper, it still is. It turns out we can complicate the model in some ways (but not others) and the result that we use just monetary policy to maximise social welfare still holds.
If we return to the case of a demand gap caused by a fall in consumption, suppose we cannot use monetary policy because nominal rates are stuck at zero. As we want to increase private consumption, the obvious alternative to try is a tax cut. If we had access to a lump sum tax (a tax that is independent of income, like the poll tax), and if consumers responded to a tax cut, then this would work pretty well too. There are two problems: Ricardian Equivalence, and there are no lump sum taxes.
If Ricardian Equivalence held completely tax cuts would be totally ineffective at stimulating consumption, but the consistent evidence is that Ricardian Equivalence does not hold. But this evidence does suggest that at least half and perhaps more of any tax cut would be saved, which means that tax cuts would have to be relatively large in money terms compared to the consumption gap. It also adds a degree of uncertainty to their effectiveness. If there is some financial limit on the size of any stimulus package (as often seems to be the case), this puts tax changes that rely on income effects at a severe disadvantage. Even if financial limits are not present, the relative ineffectiveness of tax cuts in stimulating consumption is a problem for another reason.
Lump sum taxes do not exist, so some distortionary tax (a tax that influences incentives) has to be used. This means that a tax cut violates tax smoothing. This is the idea that the best policy is to keep tax distortions constant. A tax rate of 30% is better than a tax rate of 10% in odd years, and 50% in even years. So filling the consumption gap with a cut in the income tax rate (to be followed by increases in that rate) has a cost. The more tax cuts are saved, the bigger the cost. It is highly unlikely that this cost will be sufficient to stop us trying to fill the consumption gap, because unemployment costs are far greater than uneven tax distortions. However there are costs, unlike the first best of changing real interest rates.
In contrast, using public spending to fill any demand gap is much more straightforward, as its impact on demand and employment is more predictable. But it too has a cost: we get the C to G balance wrong (too much G compared to C). Chris House has a recent post on tax cuts versus government spending as alternative means of fiscal stimulus. (Noah Smith wrote a subsequent post and Chris responded.) The proposition he wants to put forward is that government spending should only be used as a stimulus measure if its social benefits outweigh its social costs. I’m not sure that is a very helpful way of thinking about it. Far better, in my view, is to accept that the demand gap must be plugged (because the costs of not doing so are very large), and then work out the way of doing that which leads to the lowest collateral damage. That might well be an increase in G rather than a tax cut. It will almost certainly be so if there is a financial limit on the size of the stimulus.
The same reasoning can and should be applied to unconventional monetary policy, but that has to be another post.