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.