Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 11 October 2015

One reason why monetary policy is preferred by New Keynesians

I promised to write something on this some time ago, so this post is overdue. It was inspired by markets in Provence, where I have been for the last week. (hence lack of posts, and delay in publishing comments).

There are practical reasons for preferring interest rate changes (when possible) to changes in government spending as the stabilisation tool of choice, although the extent to which these are inevitable or just conditional on current institutional arrangements is an interesting question. Here I want to give an economic reason for this preference.

Imagine a monetary economy made up of independent producers, each of whom produces a unique good, where these goods are exchanged in a market. The government can be a buyer in this market, and transforms the goods it buys into useful public goods. Total consumption is what each producer chooses to buy from other producers in the market, plus the public goods they receive. Producers have preferences over private and public goods which are independent of income, and let’s initially assume that the government provides just the right amount of public goods so as to achieve the optimum balance between private and public consumption. Because people can choose to use their income to buy goods or hold money, there is potentially an aggregate demand problem.

Suppose, for example, individuals decide for some reason that they want to hold more money. They expect to sell their output, but plan to buy less. If everyone does this, aggregate demand will fall, and producers will not sell all their output. If goods cannot be stored, and if producers cannot consume their own good, this could lead to pure waste: some goods remain unsold and rot away. (If all producers immediately cut their prices, then a new equilibrium is possible where producers’ desire to hold more real money balances is achieved by a fall in prices. So we need to rule this possibility out by having some form of price rigidity.)

The government could prevent waste in two ways. It could persuade consumers to hold less money and buy more goods, which we can call monetary policy. Or it could buy up all the surplus production and produce more public goods, which we could call fiscal policy. Both solutions eliminate waste, but monetary policy is preferable to fiscal policy because the public/private good mix remains optimal.

Three comments on this reason for preferring monetary policy. First, if for some reason monetary policy cannot do this job, clearly using fiscal policy is better than doing nothing. It is better to produce something useful with goods rather than letting them rot. We could extend this further. If for some reason the impact of monetary policy was uncertain, then that could also be a reason to prefer fiscal policy, which in this example is sure to eliminate waste. Second, the cost of using fiscal rather than monetary policy obviously depends on the form of public spending. If the public good was repairing the streets the market was held in one year earlier than originally planned the 'distortion' involved is pretty small. Third, another means of achieving the optimal solution, besides monetary policy, is for the government to give everyone the extra money they desire.


  1. All good sense here.

    I fear the problems enter where the detail of "impact of monetary policy is uncertain" comes in to play. It appears that very often the consensus has become (ZIRP aside) that monetary policy has no side-effects worth worrying about and that it always works. However, the details sometimes suggest otherwise. For example:

    1) There is a transmission question. While there are many loans (in the UK, we might highlight mortgages) that have a variable interest rate that is contractually linked to base rates, this works on the "free cash" of existing borrowers.

    It's a good stabilising mechanism, but it can hit a problem when we think about new loans. Indeed, one of the stories of the crisis in the UK is that the banks largely stopped new lending, esp. to small businesses. I'm not saying fiscal is the only way to address this, but it is beyond pure monetary policy.

    2) The balance of monetary policy affects the balance of the economy. The latest UNCTAD report notes how a "stable, low inflation" monetary policy has often led to an overvalued currency in developing countries. And indeed, one might see the 80s as an example of similar in Britain. This overvaluing is great for the financial industry and terrible for other forms of export business (e.g. manufacturing, non-financial services.)

    My fear is that economists have become knee-jerk pro monetary and anti fiscal without considering these (and other) effects enough.

  2. what exactly do you mean by an optimal private/public good mix?

    1. The right number of things like schools relative to things like restaurants.

    2. The assumption that the government provides just the right amount of public goods reduces the relevance of this argument to the UK, where today we have gaps in housing, infrastructure and skills that only public investment can fill.

    3. that is exactly what I was thinking of. Surely if we agree that we do not have an optimal amount of housing and infrastructure (which I think most would for the UK now) then demand deficit is the perfect opportunity to use fiscal policy to address this balance and avoid the wasted resources whilst improving the private/public good mix.

    4. The key issue here, I think, is to keep business cycle issues separate from other fiscal considerations. There is no true optimal balance between things like schools and restaurants; at least to some extent, it's a choice that involves fundamental tradeoffs. But even a true liberal who thinks we should have more schools and fewer restaurants may prefer to keep business-cycle policy separate from fiscal tradeoffs, and thereby favor monetary policy in a recession, for monetary policy in a recession can improve matters on all fronts even if it doesn't greatly influence relative allocation of public and private goods.

      Fiscal policy can influence efficiency along non-business-cycle dimensions. Education and infrastructure have public good attributes. But if we're having a rational policy discussion (big if, these days) these issues probably ought to be addressed separately from business-cycle policy, at least when feasible (i.e., we're not near the zero lower bound).

    5. I agree that business cycle policy and achieving an optimal (or preferred) private-public mix are distinct although both point in the same direction in Britain today: reversing austerity through judicious public investment in infrastructure, environment, housing, skills and research. Longer-term the distinction matters as I would not want to disrupt this investment programme by fine-tuning expenditure to meet business cycle exigencies.

    6. I made a very long comment below which points out some of the same things. But I will add one extra comment here: it is quite possible for the government, through *fiscal policy*, to produce private goods. It is nearly impossible for the private citizen to produce public goods.

      As Simon notes in passing at the end of his article, the government can simply mail cheques to people -- that's fiscal policy. George W. Bush actually did this, mailing a $300 check to nearly everyone in the country. That will create private goods rather than public goods. And it's fiscal policy, without any of the massive downsides of monetary policy.

      The big downside with monetary policy is that it's *lending and borrowing* and that has a dangerous casino-like effect of concentrating all wealth into a small class. Fiscal policy tends to redistribute wealth from rich to poor; monetary policy tends to redistribute wealth from poor to rich (in the form of interest payments, fees, etc.)

  3. I'm pretty certain Nick Rowe made exactly this point a few months ago. Except for that last paragraph..

    Also, a tiny bit of nitpicking: you don't need price rigidity to get coordination failure. If a lot of markets are mispriced, there is no guarantee that price adjustments will lead to equilibrium prices since no one knows where the optimal price vector is at. A price adjustment in one market leads to adjustments in other markets which in turn leads to more adjustments and I don't think there is any theoretical reason for believing that equilibrium will be achieved.

    1. When writing this post I thought it was probably a poor imitation of something Nick had already done but I had never read. Agree on your main point.

    2. And my post was in turn helped by reading one of Simon's old posts (which wasn't as clear as this one). It's not an original point to either of us; it's just a question of explaining it clearly in different ways so people can see it from all angles.

      Here's my old post:

      Nick Rowe (on a friend's computer, so I can't figure out how to sign in)

  4. Dear Prof W-L,

    Your basic argument as I understand it is that monetary is preferable to fiscal policy because the former leaves the mix of public and private consumption at its optimum level (your 2nd last para).

    That assumes that the reaction of public and private sectors to a change in interest rates (the main monetary tool) is the same, which is a bold assumption. It assumes that interest as a proportion of total costs in both sectors is the same, and that elasticity of demand for borrowed funds in both sectors is the same: as I say, a bold assumptions.

    Also, the extent to which fiscal stimulus boosts private rather than public spending is easily varied: e.g. tax cuts boost private spending (though arguably tax cuts are a mix of monetary and fiscal policies). Alternatively, fiscal stimulus can be limited to just boosting public spending. Thus even if monetary policy did leave the private/public spending ratio the same, I don’t see that that’s a huge merit in monetary policy.

    1. If you make this symmetrical by allowing for periods when aggregate demand is too high, then changes in taxes to control aggregate demand are also sub-optimal because taxes are distortionary and variations imply a departure from tax smoothing. The exception is a poll tax and (for deficient demand only) helicopter money, which I refer to in the last sentence.

    2. I think the idea is to have very strong auto stabilisers do the work.

    3. But helicopter money is also a form of fiscal policy, right?

  5. Do not quite understand this.

    You say the problem is this:

    "Suppose, for example, individuals decide for some reason that they want to hold more money. They expect to sell their output, but plan to buy less." That will lead to a lack of aggregate demand.

    And then one of the solutions you suggest is:

    "Third, another means of achieving the optimal solution, besides monetary policy, is for the government to give everyone the extra money they desire."

    So clearly, the individuals who save are not ones desiring extra money.

    The logical conclusion is for the taxing of the individuals with the savings to give to the individuals who have a desire.

    That would clearly stop goods being wasted. And the private sector/public sector would still remain optimal. Without monetary policy.

    1. Here all producers are the same (apart from the good they produce), so they all want to hold more money. If the government just gives them the extra money they want to hold, they will not need to reduce their consumption of private goods.

    2. Short version: This is the "baby sitter scrip" issue Krugman mentions occasionally. A coop of friends with similarly-aged children (babies to start) agree to sit for each other on a scheduled basis, using scrip.

      As the kids age, demand for the scrip gets higher. (Going out with an infant may be inconvenient for all, but going out with a three-year-old is marital suicide.) So people decide to "save" their scrip. So no one is going out, and my need for two scrips in the future cannot be solved because no one will trade one now.

      The solution was to issue more scrip to everyone.

      There's a similar thing in the US over solar energy credits: California may have a very fluid market, but New Jersey (which is second or third in size) seizes up so often that the companies selling panels will not manage the credits at any price.

  6. Cheers for this post Simon. I believe there is a big difference between MMT and NK in that MMT allows the government first access to the nation's resources.
    Comparison here:
    The incumbent philosophy should be familiar to everybody.

    A central bank ensures there is sufficient borrowing in the economy to maintain 'aggregate demand' at 'full employment' where 'full employment' is defined as a few million people out of work give or take a few million more.
    The central bank is supposedly independent, but is really politically homogenous.
    Activity is based entirely upon the private sector, under roughly free market rules, operating exclusively and having access to all the resources of society.
    In this model the government is just another actor in proceedings that has to carve out its space 'competitively' with everybody else by taxing, spending and borrowing.
    The push is for ever smaller government with the state constantly deferring to private interests and binding its own hands ever tighter.
    If anybody is left behind it is their fault, not the fault of a system incapable of maintaining real full employment - where everybody has a job and an income.

    The result of this philosophy is all around us - vast inequality, massive private debt burdens, wage shares on the floor, insufficient investment, productivity trashed, and millions of people without a living income to sustain them. And of course eight years after a collapse we're still not back on our feet. It simply doesn't work for the majority.

    The new philosophy is very different.

    1. the state, as representative of us all, takes the resources necessary to create the critical public infrastructure and basic functions - all those that are a natural monopoly or are best treated as a natural monopoly, plus whatever is required to fulfil the critical public purpose of the people who elect them (a health service, education, etc).
    2. the private sector is then allowed to play with the rest of the resources as it sees fit.
    3. the state then takes what the private sector decides it doesn't want to use and deploys them sensibly for the 'nice to have' public purpose (Job Guarantee, mostly labour.)
    Within this philosophy the free market private sector is bookended by the public sector and sensibly contained - like any good nuclear reactor should be. Here the public sector gets first dibs at the resources of society and maintains the structures necessary for the private sector to operate at optimal efficiency and maximum output (for example, removing the need for 'jobs' in the private sector allows it to press on with automation).

    Correctly configured this philosophy actually creates a private sector that is larger than the original structure because, of course, it can maintain more of the population at a higher level of economic activity. However what it does do is remove political power from bankers and corporate leaders and we've known for decades they don't like that idea.

    1. I do not understand why the 'move order' should matter. Are you saying there is no such thing as an optimal public/private good mix?

      The basic NK model says nothing about who is operating monetary policy. If it is being done competently, the target level of aggregate demand is that which achieves constant inflation. There should be no difference between models here.

      I had thought the difference between NK and MMT is a different view about the uncertainty associated with fiscal and monetary actions, which I cover in my post.

    2. I have a lot of sympathy for your argument, Random. I would say first that the 'new philosophy' sounds a lot like the 50s and 60s (near) consensus on a social democratic approach, That is, the public goods needed were accepted as given, with a small margin for political preference, the tax rate set according to the best economic ideas of the time and the private sector left to get on with things.

      Of course, this didn't work optimally (though in a lot of ways it probably worked better than things do today) so government started trying to push private sector in certain directions (high-tech, depressed regions) and made itself pretty unpopular in the process. Hence ... where we are today.

      What may be new, and what we have to get to grips with, is the idea that deficits 'don't matter' and therefore that the purpose of taxation is to control inflation (this is my take on MMT, derived mainly from comments on this blog). Certainly, deficits matter if they signal serious supply shortages (concrete in China for example) and it becomes impossible to squeeze out inflation through general taxation. In the end, capacity in any economic system - from a small firm to a trading bloc - is limited and no economic theory, however well applied, will remove the limit in the short term. The trick is to identify the areas that are approaching their limits and find ways to stimulate supply and squeeze demand just enough.

      An example, showing possibilities, and also difficulties, might be the solar power sector in several different countries. Here the mistake - perhaps - has been to go too micro and to try to support specific solutions rather than taxing the problem (carbon emissions) and leaving animal spirits to find the answer.

      Yes, this is a little vague and wandering (sorry), but there are some important ideas behind Simon's interesting premise. The danger, in my mind, is trying to resolve at too high a level of abstraction which risks assuming away the interesting features of the challenge.

  7. Exactly! I'm still curious about your opinion on the risk with fiscal tools that, as they make the economy approach the inflation target, they trigger central banks to tighten and undo the benefits before reaching full output.

    It seems to me that if the natural rate is more negative than the inflation target is positive. That is what is going to happen.

    1. That's the other major difference between MMT and NK.
      The "natural rate" is zero.

    2. The "natural rate" concept is unfalsifiable.
      With no interest on reserves or bonds issued, excess reserves banks try to lend out leads to it to fall to zero.
      See e.g the BoE's attempts to derive it basically alchemy or at best philosophy.

    3. Benoit, it depends entirely on whether the CB actually tightens in response to fiscal stimulus.

      You are right that if the CB tightens, then the fiscal "offset" winds up crowding out private spending. But the CB might not offset, if, for example, it is falling short of its own inflation target year after year and is stuck at the ZLB. I think that's been the case in the US from 2008-2015. It's clear from Bernanke's book that the Fed did all of the stimulus it could have under political constraints, which implies that had there been fiscal expansion, the Fed would not have made any attempt to offset it,

      Kenneth Duda
      Menlo Park, CA

    4. Kenneth, to me it is not clear at all for the fed did all it could and even less clear for the ECB.

      The US has been very timid with monetary policy since 2008. They tried implementing QE but then undid the effects of their QE programs by adding interests on reserves and, for example in 2013, by giving statements that implied that if unemployment went under 6.5% they would forget their mandate and focus on lowering inflation even if inflation and GDP stayed low and unemployment stayed above full (remember this: ?). These things basically killed 90% of the effects QE could have had.

      QE money doesn't do anything if the market thinks the money is soon going to be pulled out of the economy. These hawkish stances on top of a too low inflation target, were an implicit promise to pull the money out as soon as it started to work.

      And these were not empty promises. The US is now bellow 6.5% unemployment and the fed seems to be itching to raise rates even though inflation expectations are at a record low.

      The ECB has been even worst, actually raising rates in 2011, way before they had any chance of reaching full output. What do you think that did to the likes of Greece and Spain? If there had been more Eurozone wide fiscal efforts they might have raised rates even earlier and offset those efforts.

    5. "then undid the effects of their QE programs by adding interests on reserves"
      Negative lower IOR is a tax.

  8. Yes! This is so exactly right. Thank you for this wonderful statement of why fiscal stimulus is second best.

    It's part of why the world would benefit from NGDP level targeting. You get the monetary stimulus needed to support private demand without policy failure at the ZLB. QE does not solve the problem because the markets cannot form optimal expectations about the lifetime of newly injected money, which leaves us with fiscal stimulus, which, as this post so eloquently points out, is second best to monetary stimulus (unless the government was under-consuming and under-producing public goods in our former equilibrium). Plus, this approach works even when the fiscal authority is tied in political knots and unable to enact required fiscal stimulus. I believe all of the foregoing is true in the United States 2008-2015.

    The part that the market monetarists have wrong is their notion that monetary offset is inevitable regardless of CB policy. A central bank that routinely falls short of its own inflation targets, e.g. due to policy ineffectiveness at the ZLB, will not respond to increased fiscal stimulus with monetary offset, so it is possible for fiscal expansion to help restore aggregate demand. But a central bank that is successfully targeting the level of NGDP will always successfully offset fiscal stimulus, as the market monetarists argue, i.e., their claim about monetary offset is true in their model, but unfortunately not in the world of deficient monetary policy that we all live in today. It frustrates me that market monetarists argue against second best when the first best is nowhere in sight.


    Kenneth Duda
    Menlo Park, CA

    1. You can introduce targeted tax cuts for instance. Fiscal policy does not have to mean bigger govt.
      So I disagree fiscal policy is second best.

    2. Random,
      doing it through tax cuts can induce fewer distortions but still more than with monetary tools because it distorts real after tax interest rates and the transparency in the intertemporal negotiations that they imply. It short-circuits savings as it affects proper time allocation of aggregate investment maturity structure.

      I often use a simplified agrarian economy as an example:

      Say you had an isolated farming village where people wanted to save to be able to eat in the winter. Because there is some spoilage, crops stored for the winter are only worth 90% of the initial investment required to produce them, that is they have a real return of -10%.

      In the fall, people in this village should invest into excess production to have something to eat in the winter, even if, the real returns on these investments are -10%.

      Instead, this village could mandates its government to create a currency that always keeps 98% of its real value (2% inflation) even when private market stores of value can’t retain this much. The government would put money into circulation by buying part of farmer’s crop during the summer (politicians have to eat).

      In this situation, most farmers would produce enough food for the summer, sell some of their crop and keep their money to be able to buy something to eat in the winter. They would not produce a crop to store for the winter since it would only return real -10% on their initial investment and their central bank promised to keep money at at least -2%.

      However, when comes winter, most farmers would have cash but few would have anything to sell because they wouldn't have reinvested their cash in the production of a crop to be stored!

      This is a problem stemming from insufficient demand for new capital creation (the food stockpile).

      It’s going to be difficult for the central bank to control inflation in such conditions because there will be too few goods for the amount of money people will want to spend.

      This dire situation could have been prevented if the central bank had kept money devaluating sufficiently and interest rates low enough (in this extreme case, inflation above 10%). Farmers would not have kept their savings as excess idle cash but would have reinvested them into an extra crop for the winter and have continued to trade during the winter.

      Note that there are parallels with farmers saving for the winter and a baby boom saving in preparation for retiring and stopping to work. What I essentially described is an extreme version of a combination "savings glut" and "secular stagnation".

      The MMT solution would be for government to borrow and spend in the summer to keep people working longer. Maybe they give tax breaks that makes everyone feel richer and puts people's apparent savings above what they think they need to buy food later during the winder.

      This gets people to spend on additional leisure. It puts them at full employment, but not necessarily push them towards building a stockpile of food for the winter because the extra money in their account makes them collectively think they will already be able to buy it from someone else.

      Comes winter, they still starve!

      What MMTers forget is that it is crucial what kind of capital gets created and what is the time maturity of these investment. Do we want to incentivize a stockpile of food for the winter or additional short term spending?

      MMT solutions usually disregard the important intertemporal negotiations implicit in transparent after tax real interest rates and turn economic activity that should be going towards long maturity, long lasting projects into short term projects that leave society with insufficient capacity to consume later.

    3. The old 'simplified agrarian economy' rubbish again.

      It's so stylised and full of assumptions as to be utterly useless. That is not how people actually behave.

      Farmers produce crops because they are farmers, not investment gurus! The farmer will farm crops because they have the expectation that they will sell the goods. People save to excess because they are frightened of the future or for status reasons, not because of interest rates.

      The fairly obvious solution to this 'dilemma' is for the state to purchase the crop as a buffer stock and stabilise the price over the seasons. That extra demand generates the extra production necessary, and ensures that nobody starves in winter.

      In MMT we call the buffer stock the Job Guarantee.

      So rather than stabilising the system indirectly under the mistaken belief that people respond to 'investment incentives' rationally on interest rates, you stabilise the system directly by buffer stocking the production.

      All it takes is somebody not to respond to interest rates as it says in the textbook and the village starves. Under the buffer stock system the village *never* starves.

      That's the benefit of direct vs. indirect management of an economy.

    4. This comment has been removed by the author.

    5. Sure if the government has perfect foresight as to what to spend its fiscal stimulus on and it spends it on that, it would work. You can say let's not give tax cuts and let's get the government to spend on the right things. But consider this: MMT distortions of interest rates, doesn't only affect private sector decision making, it can also make it seem to the government that it should be spending on short term stuff when it should be spending on longer maturity projects.

      So in my example above, the government too will look at the choices between spending on a crop of food and on shorter term things and given interest rates, it will seem to it like food is a bad investment. Unless bureaucrats are smart enough to see that it is their own failure to do sufficient monetary easing that is fooling their own selves into making food look like a worst investment than it is, they may not make that investment. It is already difficult for governments to optimize allocation of capital and resources. It becomes even more so when things get clouded by having variable taxes and inflation and interest rates that give you little information about temporal tradeoffs.

      Of course, a much better solution would simply be to allow real interest rates to go sufficiently negative to their market equilibrium relative to predictable taxes and inflation. This would make the relative value of investments with different maturity structures more transparent to both private and public sector decision makers. Once you sufficiently stimulate to do that, fiscal policy is probably not necessary anymore as it will likely already get you to full employment.

    6. "MMT distortions of interest rates, "
      See, I'm not really sure what you are talking about.
      Without any interest on reserves or bonds the interest rate is zero. That's the "natural" rate, as banks will try to lend in the interbank market but can't get rid of the excess.

    7. Please read:
      "It is already difficult for governments to optimize allocation of capital and resources."
      Huh? What? No it isn't.
      It is difficult to do so with monetary policy though:
      "Monetary policy is what we call an indirect policy tool. By changing interest rates it makes borrowing more or less expensive and this is designed to influence behaviour. But investment decisions such as building a new plant are based on longer-term expectations of the net flow of returns and the current flow of investment spending is not particularly sensitive to changes in current interest rates.
      Further, no matter how low interest rates go, borrowers will not borrow if they fear unemployment. Firms will not invest if they are worried that consumers will not be driving sales growth."

    8. "That's the "natural" rate, as banks will try to lend in the interbank market but can't get rid of the excess."

      As banks make more loans the deposit to reserve ratio will increase and the interest rate on reserves will rise.

    9. IOR is set by the central bank.

    Here is an example in South Korean govt using proactive fiscal policy.

  10. Market Fiscalist11 October 2015 at 14:19

    On "It could persuade consumers to hold less money and buy more goods, which we can call monetary policy".

    Couldn't "It could buy assets for for new money so that consumers demand to hold money can be met at the current price level" also be called monetary policy ?

  11. Is this similar to Krugman's Sam, Janet, and Government Gus post but with the new character Helicopter Harry? (Krugman blog October 25, 2010, 7:35 am, Sam, Janet, and Fiscal Policy.)

  12. Hasn't the experience with loose monetary policy been that it leads to financial bubbles, while with fiscal policy you can better target where funds go? For example, if you have tax cuts for low income earners and expenditure on work placement schemes (with a better controlled immigration policy which has barriers to inflows of cheap labour, but not highly skilled labour or refugees), this increased disposable income for a large income constrained group should be the foundation of a broad based recovery.There is also a lot of historical evidence, and classic literature which goes back a long way, which suggests that loose monetary policy is associated with income inequality. Also what do countries that perform well do (in terms of standard of living and egalitarianism)? My guess is that they have tight monetary policy with fiscal activism and centralised wage fixation systems.

    I do believe that JMK talks about all these things, and I understand that Piketty has similar views.

  13. You sound like you may be interested in MMT ideas we have covered them in detail:
    Banking - regulate what banks lend *for* aka asset side discipline:
    Employment - Job Guarantee - open job offer at the living wage, much better than NAIRU approach, allowing full employment and price stability:

  14. You have defined Monetary and fiscal policy in a very idiosyncratic way that bears little resemblance to the policy choices or institutional constraints facing governments:

    "The government could prevent waste in two ways. It could persuade consumers to hold less money and buy more goods, which we can call monetary policy. Or it could buy up all the surplus production and produce more public goods, which we could call fiscal policy. Both solutions eliminate waste, but monetary policy is preferable to fiscal policy because the public/private good mix remains optimal."

    Fiscal policy is primarily about running budget deficits, which comes from mailing out checks and cutting taxes. It has very little do with government purchase of goods.

    On the other hand, the idea that the Government can "persuade consumers to hold less money and buy more goods, which we can call monetary policy" has nothing to do with monetary policy as practiced by Governments, which is interest rate management.

    Really, this is a better description of fiscal policy, because when the government mails out an unemployment check, or spends more on pensions, or makes a purchase tax deductible, then this has a much greater effect on influencing decisions to hold money or goods than an interest rate adjustment.

    So while it's nice to conceptualize monetary and fiscal policy in such a way that one is clearly preferable to the other, the cost of doing so mixes them up so completely that no policy guidance is available to be learned from this alternate reality.

  15. At the same time, there are enormous distortions as a result of interest rate management as soon as you allow risk assets and credit constraints into your model. Those who can't borrow because they lack collateral are going to be affected differently from a change in rates. A cit in rates changes the price of risky collateral less than it does the price of risk-free collateral. This introduces distortions as well. Are these distortions worse than the distortions of running a deficit and sending a check to everyone? It's not clear at all. Certainly not reason enough to directly bias one policy over another.

  16. On the other hand, there are many advantages to using tax policy over monetary policy.

    1) Monetary policy is limited by the zero bound. Tax policy is not. Levying a tax on capital income (including interest income) can easily create negative interest rates.

    2) Moreover, tax policy is not one size fits all. We can apply one tax rate to one group and another to another group.

    3) Tax policy can redistribute incomes when an income adjustment is needed to restore demand.

    4) Deficit policy is objective and faster. We have never managed to get Central Banks to follow an automatic rule, but automatic stabilizers have a long history of success and work in real time -- the moment someone is laid off, the stabilizers kick into effect for them. If it happens that more are laid off than normal, a deficit is created, even if the employment data are not yet out. There is no ideological filter in which a group of old men peer at the tea leaves and consult their favorite models before deciding to raise or cut rates.

  17. Sounds not convincing to me. You write:

    "Or it could buy up all the surplus production and produce more public goods, which we could call fiscal policy"

    you probably forgot:

    -- or the government could reduce income taxes. This would be fiscal policy, too,but keep the Private/public goods mix.

    The disadvantage of monetary policy is that a change in the in the level of interest affects different induistries differently and will distort the product mix.

  18. How can this be New Keynesian given that there are no investments, no firms and no work force?

  19. I think interest rates a poor tool to control bank lending. Control it directly:
    "British Banks don't do their job. That job is the distribution of new state backed money to those who can make use of it to develop the capital of the country. The problem of getting lending to businesses has been around for a very long time.

    The lending banks we need are the ones that can lend development capital effectively and stick to doing just that. If we are to have private lending banks, then they need to be able to make a decent profit doing development capital lending.

    The way I would narrow banks is to offer them an incentive - an unlimited cost free overdraft at the Bank of England. 0% funding costs. In return they must drop all the side businesses and just do capital development lending on an uncollateralised basis - probably in the form of simple overdrafts. In other words they become an agency businesses delivering state money to those that require it.

    I'm not even sure a capital buffer is required here. Losing your lending licence if your underwriting isn't that good should be sufficient incentive to run a tight ship. Backing off the entire thing to the central bank reduces the barriers to entry in lending - making self-employed, highly dispersed and, importantly, locally focussed underwriters a possibility (the 'Provi Model').

    Any lending businesses that doesn't want to take the oath, then has to fully fund their lending on a maturity matched basis Zopa style. No deposit insurance, no access to the Bank of England, and losses absorbed by those doing the lending. This then becomes the fate of the shadow banking system - the building societies and money funds.

    So that sets state funded lending against fully match-funded lending in competitive tension. State funding will likely be conservative but actually injects extra net financial assets into the non-government sector economy. Fully funded lending is just patient man helping impatient man for a fee in return for the risk.

    Now narrowing banking in any way will put the cost of lending up markedly - particularly if you de-collateralise to get away from asset bubble spirals. With the current level of loans that is likely to cause fun and games. So you have to get the total amount of lending down at the same time as the narrowing is put in place."
    But both are inferior to fiscal policy.
    MP wouldn't work as well if the City was less powerful and there was housing bubbles, which many on the left want to stop.
    IMV, land value tax to stop housing bubbles and very strong auto stabilisers (progressive taxes and a Job Guarantee) are needed.

  20. "...let’s initially assume that the government provides just the right amount of public goods so as to achieve the optimum balance between private and public consumption."

    AFAICT, this assumption is doing all of the heavy lifting here. If we assume that if the government's share of the economy was larger it would be too high, then increasing the government's share of the economy would indeed make it too high. Fiscal policy can add demand but leaves the economy unbalanced. Monetary policy fixes the demand shortfall without unbalancing the economy. Therefore monetary policy is preferred in this situation

    But if you change the initial assumption to an economy with a significant shortfall in government provided goods, then the end result of monetary policy is raised demand but an unbalanced economy...i.e. precisely the reason why fiscal policy wasn't preferred in the previous argument. By contrast, fiscal policy raises demand and leaves the economy better balanced, the same reasons why monetary policy was optimal in the last situation.

    Changing the initial assumption about the balance of the economy, as far as I understand, determines the conclusion of the argument. Which doesn't answer the question of why New Keynesians prefer monetary policy to fiscal unless they have an argument for why we should believe that the economy already is either optimally balanced or tilted too far in favor of government spending already.

    And as I live in a country that needs eye-watering amounts of money invested into rebuilding its infrastructure, decarbonizing the economy, and preparing for climate change to stave off disaster, the assertion that we're already at or beyond the correct level of government spending is...implausible.

    What am I missing?

    1. The thing is the "govt share" should be decided democratically.
      IMV we need to trim back the City's amount of "private" goods and non jobs ;)

    2. Alexander. It is really important to understand what model assumptions do. I was not saying that in the real world this mix is correct. But I think its conceptually useful to separate the problem of stabilisation and the problem of the correct size of the state. Using the former to achieve to deceitfully achieve the latter can be harmful. Otherwise you are absolutely right - if you have too little demand and too few public goods relative to private goods, fiscal policy can kill two birds with one stone.

  21. Simon, if I've read this right then one of the reasons for preferring monetary policy is that it doesn't require the government to choose to do anything directly (consciously?) to alter the public/private goods mix (perhaps because it would be as likely to take a bad decision as a good one). That then would be a good reason for choosing helicopter money when monetary policy hits a lower bound constraint as Govt would then just let the producers/consumers sort out the AD problem as they see fit? (ie it's the policy which minimises the number of things that the government needs to know and so maximises the probability of getting the desired effect). Is that roughly right?

  22. It is a clear exposition, and it does seem New Keynesian. Free of any school-discipline:
    Monetary policy has several charms for a macro-stablisation, apart from being neutral there is the swiftness in reaction, and a dedicate task-force. It can address domestic spending well to a limited extent, which suffices well for finetuning in normal times, and besides there is the effect on the exchange rate. Thus, the case for fiscal policy is to be found in a deep dragging global depression, and I am afraid that is just the case we have been in. The relevant case is up ahead.
    It is not New: Keynes turned to fiscal policy during a depression since 1925, because he became disappointed in the Bank of England, not because he got the view that monetary policy had lost its value irrespective of the condition.
    (For the record: the Bank of England can be staffed by fools and politcs can be run by geniusses, theoretically.)

    Concluding, there are differences of taste on the music of:
    "First, if for some reason monetary policy cannot do this job, clearly using fiscal policy is better than doing nothing"
    Bernanke and Draghi called for politics to step in as they felt like Churchill in 1940, digging an escape-tunnel with a fne-tuning spoon. They would prefer: "as, in these years, for some reason ... "

  23. SW-L
    What world are you describing there in your explanation, because it is not the one we live in?
    Where are loans and banks and debts? Because any simplified story without it does not compare to the real world.

    When you say that "people want to save more" which implys good morals acctually means that people spend larger portion of their income to servicing debt then before (partly because total income fell and partly because tighter interest rates then before even tough official rate is lower, but in real world banks do not follow official rate bellow 2%). More money proportionaly goes to debt service then before is correct term instead of "people want to save more money".

    What is the implication of using correct description from real world instead of assumption like these?
    It is that monetary policy can not work and mix of fiscal/monetary have to change in order to improve an economy. Implication is that you can see that only fiscal policy can work to help pay for servicing loans and reduce private debt in order to restart lending which was the source of demand when wages were stagnant for so long.

    1. Economists use simple models to get key concepts across. This works if they are robust to complication, and my work with more complicated models suggests in this case it is.

  24. "The government could prevent waste in two ways. It could persuade consumers to hold less money and buy more goods, which we can call monetary policy. Or it could buy up all the surplus production and produce more public goods, which we could call fiscal policy."

    Or the government could create and hand out new money to the population, until both the dire to hold money is satisfied and all goods are sold. This is a form of fiscal policy you didn't mention.

    1. What did you think the last sentence was about!

  25. Is there anything wrong with the theory that existed before Keynes:

    Monetary policy is a string. It can be pulled or then loosened, but it cannot be pushed.

  26. How does monitary policy in the short run affect the economy in the long run?

  27. OK, this reasoning has a gigantic hole in it, which you've missed.

    Having more money in my pocket does NOT enable me to buy more public goods.

    So if monetary policy gives me more money in my pocket, but I want to buy more public goods, I'm SOL.

    As a result, monetary policy has a strong bias towards private goods, and tilts the balance away from public goods in an detrimental way. It *damages* the balance, preventing the correct balance between public and private goods from being achieved.

    This is not theoretical. This is proven fact. Many of us here in the US would love to buy more public goods such as a National Health Service -- but we can't, so we're forced to spend extortionate amounts of money on private health insurance. Most of us would love to pay for more public goods such as sidewalks (missing in most communities), better road maintenance, train service, etc. etc. etc. etc. etc. etc. But we can't. As a result we waste money on buying gasoline (private good).

    To get those public goods, we need the GOVERNMENT to pay for it, and the government keeps pleading poverty and claiming that it can't run higher deficits -- even though it can do monetary policy no problem...

    in short, we have a structural problem with insufficient supply of public goods *right now*. A preference for monetary policy exacerbates this problem. A preference for fiscal policy will rebalance the scales towards public goods where it *belongs*.

    I hope you understand this. It really demolishes the entire argument in your article.

    There's a second, even larger problem with monetary policy: it's borrowing. The result is a highly indebted populace -- roughly half of the US population has no net worth, last I checked. Fiscal policy actually increases people's wealth -- monetary policy does NOT, it only increases people's liquidity.

    As more and more people end up deep in debt, monetary policy consists, eventually, of lending to already-rich people because nobody else is credit-worthy. At this point it becomes completely ineffective, because already-rich people have a very low propensity to spend. By this time, the superrich have enough money to buy all the politicians and steal elections, and your country is in *dire* straits. (We are there in the US. You can still avoid it in the UK.)

    Fiscal policy can transfer wealth directly to the poor and middle class -- it can have a redistributionary effect. *By definition monetary policy cannot*, it can only make the rich richer.

    This is the fundamental problem with monetary policy. It should be avoided whenever fiscal policy is possible.

    I think it's really shallow for New Keynesians to not understand this stuff. It's *basic*.


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