Monetary vs. Fiscal Policy

Brad DeLong

University of California (Berkeley) economist Brad DeLong took my late-in-life education on economic issues to a new level. I’ve plenty more to learn, of course, but I enjoyed his discussion.

Here’s a snippet from his article in the Seeking Alpha web site:

In such a setup, the conclusion of Mankiw and Weinzerl that monetary policy has the exclusive role to play is straightforward: One stabilization policy tool–monetary policy–is non-distortionary. The other stabilization policy tool–fiscal policy–is distortionary. If monetary policy can do the job, there is then no need for fiscal policy. And if you do resort to fiscal policy, use the fiscal policy that is most effective at getting people to spend money on the things they were at the tipping point of buying anyway–use the investment tax credit rather than direct government purchases or tax cuts which might well not be spent. End of argument.

Well, actually it wasn’t the end of his argument. He goes on to assert that well-designed fiscal policy is as important and powerful as monetary policy during unusual times like we are experiencing right now.

Prof. DeLong’s discussion is a bit tough going for Principles students. Let me see if I can translate.

In normal times, when short term interest rates are noticeably above zero, monetary policy is often the best tool for government to use to correct the economy. In class we talk about correcting for either a recessionary gap or an inflationary gap. DeLong agrees with Mankiw and Weinzerl that monetary policy is sufficient and does less to distort the marketplace. What does he mean by distortion? In a perfect economic world individuals make decisions on whether to save or spend and if they spend, on what kind of things. When government decides to spend additional money (i.e. uses fiscal policy) then that means it must raise taxes to pay for that spending. Those taxes change, or distort the decisions that rational individuals would make. This moves us away from our theoretically perfect model of allocating resources.

Potential vs. Actual (Real) GDPPotential vs. Actual (Real) GDP

As a side note, much government spending is valued by the public and helps correct problems in the market or helps society meet other goals – such as caring for the disadvantaged. So spending and taxes aren’t necessarily bad for those kinds of goals, but spending to stimulate an economy does potentially distort how we would use our funds. In my classes I also point out that fiscal policy is usually a pretty blunt instrument, wielded by not very expert politicians. There are all sorts of time delays, political compromises, and imperfect implementation. So, monetary policy is often the best way to solve short term, mild-to-moderate problems in the economy.

Back to DeLong. He agrees with Mankiw and Weinzerl, but goes on to argue that monetary policy has a hard time working during a liquidity trap – when short term interest rates, and the interest rate target set by the Federal Reserve are so close to zero that pumping more money into the economy just gives it bloat, rather than relief.  In these tough times, monetary policy can possibly work if the Fed promises to keep interest rates lower and inflation higher in the future. However, DeLong points out that future Fed committees are not bound by the promises of today’s leaders. If investors think there will be a change of heart, and interest rates will rise in order to force inflation lower, then those investors will delay their spending plans.

On the other hand DeLong argues that an aggressive fiscal policy – i.e. more spending now, backed by printing more money, can have a strong impact, and the government will be less likely to back down from its policies in the future.

DeLong also argues that monetary policy can introduce distortion – by changing the relative amount  we invest in projects with short term benefits versus those with long term benefits.

Here’s the last summation:

It is important to get the overall level of production right–to match total spending to potential output. It is also presumably important to direct spending toward high-value commodities. It is important to get the balance between private and public purchases right. And it is important to get the balance between short-duration and long-duration assets right.

Thus fiscal and monetary policy are likely to both have proper stabilization policy roles to play.

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