Brad Delong and Larry Summers on the ineffectiveness of fiscal policy in stimulating the economy
05 Jul 2014 3 Comments
If there is such a thing as a liquidity trap, bring it on!
04 Jul 2014 Leave a comment
in business cycles, fiscal policy, macroeconomics, Milton Friedman, monetary economics Tags: Allan Meltzer, JM Keynes, liquidity trap, Milton Friedman
In the Keynesian pipedream, in a liquidity trap, there is perfect substitutability of money and bonds at a zero short-term nominal interest rate. This renders monetary policy ineffective.
Keynesians claim that the demand for money may be so persistently high that the rate of interest could not fall low enough to stimulate investment sufficiently to raise the economy out of the depression. Allan Meltzer explains:
A liquidity trap means that increases in money by the central bank (monetary base) cannot affect output, prices, interest rates or other variables. Changes in the money stock are entirely matched by changes in the demand to hold money.
With a liquidity trap, the public simply hoards the money the central bank creates rather than attempting to run down additions to their cash balances with increased consumer expenditure. This limitless accumulation of money by the public is not a real world phenomenon. The public will not forever accumulate money.
Auerbach and Obstfeld noted in "The Case for Open-Market Purchases in a Liquidity Trap" that to the extent that long-term interest rates are positive short-term interest rates are expected to be positive in the future, trading money for interest-bearing public debt through open market operations reduces future debt-service requirements.
- A massive monetary expansion during a liquidity trap should improve social welfare by reducing the taxes required in the future to service the now much smaller national debt!!!!
- A quantitative easing during a liquidity trap is, in effect, as good as or even better than a lump sum tax.
Central banks perhaps should contrive liquidity traps because they can then buy back the public debt because of the unlimited demand for money.
The logic of the liquidity trap is people will without limit give up bonds for non-interest bearing cash. If monetary policy is impotent near the zero bound, the central bank should buy trillions of dollars of federal bonds and payoff the public debt. This is a logical implication of liquidity traps for an optimal fiscal policy!!!! Is my reasoning wrong?
In addition to D.H. Robertson, Jacob Viner, Milton Friedman, Philip Cagan, Don Patinkin, Auerbach and Obstfeld, Robert H. Lucas, Greg Mankiw, and Bernanke and Blinder as sceptics about a liquidity trap, Keynes wrote in 1936:
Whilst the limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test.
Meltzer, who wrote A History of the Federal Reserve, Vol. 1: 1913-1951 points to several periods when interest rates were at or close to zero:
“In 1954, interest rates were 0.5 percent or below, and we had no problem recovering,” he says. “In 1948 to 1949, we had zero interest rates. Also in 1937 to 1938. We had no problem recovering.”
The Pigou effect states that when there is deflation of prices, employment (and output) will be increased due to an increase in wealth (and thus consumption). The deflation increases the value of cash balances and therefore the wealth of consumers. They spend some of this additional wealth.
After reading the annual reports of the Fed in the 1920s and 1930s, Milton Friedman noticed the following pattern:
In the years of prosperity, monetary policy is a potent weapon, the skilful handling of which deserves the credit for the favourable course of events; in years of adversity, other forces are the important sources of economic change, monetary policy had little leeway, and only the skilful handling of the exceedingly limited powers available prevented conditions from being even worse
Repeat after me: fiscal policy is ineffective when there is a flexible exchange rate!
04 Jul 2014 2 Comments
in fiscal policy, macroeconomics Tags: exchange rate crowding out, fiscal policy, Mundell Fleming model
New Zealand, Australia, and most other economies are small open economies. Any expansion in the budget deficit will drive up the exchange rate because of the higher interest rates. This appreciation of the local currency in response to the capital inflow will make imports cheaper. Any increase in so-called aggregate demand will simply result in an decrease in net exports. There will be no increase in local production or employment.
- a fiscal expansion puts upward pressure on the domestic interest rate
- But this immediately invites a massive capital inflow.
- This appreciates the nominal exchange rate.
- This will decrease net exports, since we are able to import more goods and services with less money because of the currency appreciation, while foreigners will import less of our products because of our appreciated domestic currency
- The exchange rate appreciates and the trade balance worsens until the initial increase in government spending is completely offset.
Under a floating exchange rate and high capital mobility, fiscal policy is ineffective in stimulating the economy because of exchange rate crowding out. The appreciating exchange rate will increase imports and reduce exports to render fiscal policy impotent or at least to shadow of its former closed economies self.
Does a fiscal stimulus stimulate?
26 Jun 2014 Leave a comment
in applied price theory, budget deficits, business cycles, fiscal policy, macroeconomics Tags: Eugene Fama
What did fiscal policy do in World War II?
23 Jun 2014 Leave a comment
in fiscal policy, macroeconomics Tags: fiscal policy, Lee Ohanian, Robert Barro
It is ironic that both camps use World War II as evidence that the fiscal policy might work (Keynesian macroeconomics) or it does not work (Barro and Ohanian).
The nature of the new spending and how it was financed both matter, as does whether the new spending was a public good, a private good or a general or contingent income transfer matter, and whether the new spending was tax or bond financed all matter to the income and substitution effects of taxes and the additional public debt.
World War II was a temporary increase in government military purchases that will be followed by a long period of primary budget surpluses and perhaps surprise spikes in price inflation to pay down the massive wartime debt.
- A military build-up financed by debt lowers consumer wealth which induces households to consume less leisure and work more while the temporary nature of the fiscal shock increases labour input through inter-temporal substitution of labour into the period of lower taxes.
- The increase in the supply of labour leads to a fall in productivity and real wages. Inter-temporal substitution of labour also raises the real interest rate and lowers private investment.
Barro found that World War II U.S. defence expenditures increased by $540 billion per year at the peak in 1943-44, amounting to 44% of real GDP. this increased real GDP by $430 billion per year in 1943-44 – a multiplier was 0.8 (430/540). The main declines were in private investment, non-military government purchases, and net exports. Wartime production was a dampener, rather than a multiplier.
The war-based multiplier of 0.8 overstates the multiplier that would apply to peacetime government purchases. Public spending crowds out private spending wartime because of intertemporal substitution of labour and consumption smoothing so private investment falls substantially.
People expect the added wartime spending to be temporary so consumer demand will fall by less. Consumers saving less to smooth out the changes in consumption relative the changes in their current after-tax income if the war is expected to last no more than a few years and no major destruction of capital stock and population is anticipated.
Korean War expenditures were financed mostly by higher taxes resulted in a much lower output and welfare compared to the tax smoothing policy for World War II.
The US borrowed heavily to finance World War II as did for most of its previous wars. This means the tax rises necessary to pa for the war debt were spread over a much longer period of time and would in consequence have less effect on labour supply and investment.
In the Korean War, taxes were increased immediately to finance the war. In consequence,labour supply and investment dropped immediately during the period of high taxes
Britain taxed capital income at a much higher rate than the United States during the war and for much of the post-war period. Lee Ohanian explains what happened:
British capital income tax rates rose substantially during the war—they approached 90 per cent—and remained high after it.
Not surprisingly, savings and investment were close to zero over this period, reflecting the very low after-tax return to savings.
In time, London reduced tax rates on savings and investment—and, as a result, savings and investment began to rise, increasing from about 3 per cent of British GDP in the early 1950s to 20 per cent of GDP in the 1980s.
But before its capital income tax rates fell, the United Kingdom was among the slowest growing countries in the industrialized West.
Utopia, you are standing in it! 
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