Many economic models are symmetrical. If higher business costs lead to higher prices, then lower business costs lead to lower prices. Thus if higher raw tobacco prices lead to higher cigarette prices, then lower tobacco prices lead to lower cigarette prices. This simple concept actually confuses students. They get the part about higher prices, but are skeptical that firms will lower prices to consumers just because costs fall. They think firms are selfish. What they don’t get is that firms will lower prices precisely because they are selfish.

I think it’s helpful to think in terms of specific numbers, not higher and lower. Thus consider the profit-maximizing price for cigarettes if:

1. Tobacco costs $10/pound P = _______
2. Tobacco costs $12/pound P = _______

Now consider the prices that would be written into each blank space. Which one is higher? That’s it. Just asking the question this way pretty much suggests the model is symmetric.

Some people accept the fact that the Fed offset the recent fiscal austerity in 2013. After all, Paul Krugman suggested 2013 was a test of monetary offset, and GDP growth sped up significantly in 2013 (using Q4 to Q4 data.) Furthermore, Fed officials cited the need to offset fiscal austerity when they adopted in more aggressive forward guidance and QE3. I’m continually surprised, however, by the fact that some commenters see the relationship as being asymmetrical. They say that tighter fiscal policy will lead to easy monetary policy, but not vice versa. I suppose anything is possible, but the Fed would have to have a truly bizarre objective function to behave in such a fashion. Here’s Matt O’Brien:

Government spending, though, can flood the economy with money, raising prices in the process. So the Fed, in turn, would either raise rates to offset this spending it doesn’t want, or wouldn’t cut rates like it otherwise would have.

Either way, the Fed’s actions would keep the economy from being any bigger with more government spending than it would be without it.

But this calculus changes when there’s a recession, especially if interest rates are at zero. In that case, the Fed wouldn’t want to neutralize stimulus spending. So GDP would grow at least as much as spending does — what economists call a multiplier of one — and maybe more since there could be spillover effects.

I wonder if people get confused by the language. O’Brien says the Fed “wouldn’t want to neutralize stimulus spending.” OK, but if there was no fiscal stimulus would the Fed do more? If not, why not?

I think people also get confused by the concept of a “neutral” monetary policy, where the Fed is “doing nothing.” Then from the neutral position the Fed can “do something,” like expansionary and contractionary policy. The same confusion applies to fiscal policy. In fact, there is no benchmark, just more or less expansionary/contractionary fiscal policies. And if tighter fiscal makes the Fed do more, then refraining from tighter fiscal (i.e. stimulus) will make them do less than otherwise.

R.D. over at Free Exchange gets the nuances exactly right:

Here it would be prudent to mix in a bit of realistic policy. Take the euro area. Inflation is just 0.3% and the area is already awash with unemployed workers. Add to that the fact that France is missing its deficit target but–as Charlemagne reports this week–will come under pressure to put that right quickly. This means austerity. Italy, at risk of a sovereign downgrade, will feel it too. Finally add a bit of political economy. Suppose that France and Italy use political capital getting some breathing space for fiscal policy, and end up being profligate in the eyes of Germany and the Netherlands. That puts the hawkish German and Dutch view in the ascendancy when it comes to monetary policy. You end up with both fiscal and monetary policy being relatively tight.

As the fiscal authorities do more, the ECB will do less. However the opposite is not true, a change to a more expansionary monetary policy will not be offset by fiscal austerity. That’s why only the ECB can generate faster nominal GDP growth in Europe.

Is there any other way to generate growth in the eurozone? I suppose they could make Martin Feldstein dictator of Europe. Let him work his supply-side magic. But that’s perhaps even less likely than the ECB finally seeing the light.

In the US it’s not at all clear that fiscal and monetary policymakers even agree on the goals of policy. Just a few months ago the Obama administration argued that the unemployment crisis was so severe that we needed an emergency unemployment insurance program that extended benefits to 73 weeks, far more than during the worst of the previous recessions. At the Fed however, things are quite different. Here’s James Bullard, a moderate who is considered a swing voter:

In his comments to reporters, Mr. Bullard said “I think there’s a risk” in holding off on rate hikes until the middle of the year. “We should act on good news. We’ve got a pretty good performing economy. We should be willing to remove some accommodation,” and it would be better to get this process started and not wait too long, he said.

The debate is over whether to raise rates in the spring or the summer, not whether to raise them at all. (And recall that a promise to tighten next year means policy is tightened right now–the expectations channel.) A “pretty good economy” doesn’t need an emergency unemployment insurance program. It’s not just that Obama and the Fed aren’t on the same page; they aren’t even in the same library. The Fed would never sabotage fiscal stimulus? Sure, they’d never say they were doing so. They’d probably never believe they were doing so. But yes, they most certainly would do so, as we saw in 2009.

HT: TravisV