Sunday, December 28, 2014

Fed's Dirty Little Secret II

David Beckworth has expanded on his argument that the Fed's policy of quantitative easing was relatively ineffective because it did not permanently increase base money.   He points out that there is plenty of evidence that quantitative easing increased aggregate demand some.   I suppose the obvious point is that the reason why a huge amount of quantitative easing had a small impact on aggregate demand is that it is expected to be temporary.   In both the posts Beckworth said that he favored a nominal GDP level target, explaining that whatever portion of the increase in base money needed to get nominal GDP to the target would be permanent and so effective.

Beckworth also criticized Krugman's defense of advocating fiscal policy.  In Krugman's view, due to obstinate Republicans, there was little chance that the Fed would undertake the sort of regime change necessary for monetary policy to be effective.   That leaves fiscal policy.

My view is that if the problem is that Republican's are obstinate, then fiscal policy is a nonstarter.   Fiscal policy is rife with political controversy due to allocation and distribution issues.    Sure, a permanent decrease in marginal tax rates combined with a credible plan to slow the growth of government spending and gradually balance the budget might expand aggregate demand immediately.  But that is hardly what Krugman had in mind.   And yes, a temporary increase in government spending with the future interest cost funded by taxes on the rich might work as well.   Why would anyone think that it makes no difference?    Of course, if you are a committed partisan, then "fix the recession" is really just one more arrow in the quiver to support your team.

Whose taxes should be cut?   Whose preferred government programs should be expanded?

Beckworth, however, argues that Krugman (and I) are mistaken to believe that fiscal policy could work.    He argues that for the same reason that the increase in base money is temporary and so largely ineffective, any fiscal policy action will necessarily have a limited impact on aggregate demand.

Let's first review Krugman's standard new Keynesian argument for fiscal policy.   First, the way that monetary policy increases aggregate demand is by reducing the real interest rate.    In the models, this causes each individual to seek to substitute current consumption for future consumption.   In the models, with representative agents and consumption only, this is impossible.   What really happens is efforts to increase current consumption increase real income.

The way the central bank reduces the real interest rate is by lowing its target for the nominal interest rate.    Given that inflation expectations are well behaved and more or less on target, this reduces the real interest rate.

However, at the zero nominal bound,the nominal interest rate cannot be lowered.   And so, the only way to reduce the real interest rate is to raise the expected inflation rate.    This is how Krugman insists on characterizing any regime change.   Somehow or other expected inflation must increase so that the real interest rate decreases and aggregate demand increases.

Increased government spending raises aggregate demand without there being any need for a lower real interest rate.   Even if Ricardian equivalence hold, the increase in government spending is only partly (and presumably slightly,) offset by reduced current consumption.   Taxpayers reduce their consumption a bit over all future periods.

Under "normal" circumstances, an increase in government spending requires the central bank to increase its target for the nominal interest rate.   This crowds out current consumption enough so that consumption plus government spending remains equal to productive capacity.   Failure to do this would result in an unsustainable boom and inflation rising above target.

However, if consumption plus government spending is below potential output, then this is not an issue.  In fact, the simple models imply that inflation will be below target unless the nominal interest rate falls or government spending rises.

I am sure Beckworth understands all of this.   And, like other Market Monetarists, doesn't see this as how monetary policy works.   Monetary policy is about changes in the quantity of base money, with the "baseline" thought experiment is that they are permanent.   While these changes in the quantity of base money have a liquidity effect, a transitional impact on nominal interest rates, it isn't the change in interest rates that causes aggregate demand to change.  

With Beckworth's framing, if the Fed is committed to return base money to its previous growth path, then future aggregate demand will not have changed much.   And so current aggregate demand won't change much.   And so, other things, such as fiscal policy, cannot impact aggregate demand much.

It seems to hang together.

One obvious problem is a question of causation.   Only a permanent increase in base money will cause aggregate demand to rise much.   But that doesn't mean that given the growth path of base money, something else, such as a temporary increase in government spending might cause aggregate demand to rise.

I think Beckworth's intuition is that the Fed is implicitly committed to keeping base money high enough so that inflation doesn't fall much below two percent.   To the degree that a temporary increase in government spending would otherwise push inflation above 2%, then the Fed is going to make just that much less of the extra base money permanent.   Put this way, the argument is a bit puzzling.   It appears to be about how fast the Fed will shrink base money at some future time when the economy is growing strongly.

Suppose the Fed followed Christensen's proposal that it keep on the current 4.5% growth path for nominal GDP.   How could it do so?   By making permanent changes in base money.   The change in base money will be permanent as long as that is what is needed to keep nominal GDP on the target growth path.

If nominal GDP could be kept on that growth path with permanent changes in base money, then changes in government spending would be irrelevant.   They would be offset by permanent changes in base money.

But that isn't the world we live in.

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