In 1968, Congress enacted a major tax increase to control inflation, eliminating the budget deficit. It didn’t work. Monetary policy became more expansionary and inflation increased still further. This was a major failure of the Keynesian model, and it helped lead to a revival of monetarism.
In 1981, taxes were cut and military spending was increased, sharply boosting the budget deficit. Keynesians expected higher inflation. Instead, a tight money policy by the Fed led to recession and lower inflation. This led to a “New Keynesian” model that de-emphasized fiscal policy.
In 2021, fiscal stimulus was accompanied by monetary stimulus, which boosted both growth and inflation. That fit the traditional Keynesian model.
The facts are not controversial, but there is some dispute as to how we should view this data. Today, I received an email from the ECB discussing a new working paper. This description caught my eye:
Lukas Hack (University of Mannheim), Klodiana Istrefi (Directorate General Research, ECB, and CEPR) and Mathias Meier (University of Mannheim) present evidence on the role that US monetary policy plays in how fiscal spending affects the economy. A dovish Federal Open Market Committee (FOMC) delays policy rate increases, while a hawkish FOMC tightens monetary policy more promptly, following increased fiscal spending. The authors then show that the dovish response supports fiscal expansions. In contrast, the hawkish response results in a GDP decline but effectively controls inflation expectations.
In one sense, that’s completely in agreement with the examples that I just provided. But the framing is odd. The comments seem to suggest that fiscal policy drives aggregate demand, while monetary policy plays only a supporting role. In fact, it is monetary policy that explains how the economy reacts in all three of the cases discussed above, whereas fiscal policy is informative in only one case (2021). Wouldn’t it be more useful to ignore fiscal policy entirely and simply focus on what monetary policy is doing? Couldn’t the final sentence be re-written as follows:
“The authors then show that dovish monetary policy is expansionary. In contrast, hawkish policy results in a GDP decline but effectively controls inflation expectations.”
Just delete all mention of fiscal policy.
READER COMMENTS
Matthias
Dec 20 2023 at 6:16am
Well, fiscal policy can still have real impacts, can’t it?
And I guess it’s also interesting to study the impacts of fiscal policy on what happens when you have an inflation targeting central bank. (If I remember right, expansive fiscal policy leads to the higher interest rates (to keep inflation on track) which leads to capital inflows? In any case, something worthwhile to study, even if the central bank’s thermostat deletes all impact on inflation.)
Scott Sumner
Dec 20 2023 at 12:40pm
Yes, it matters. But in this post I’m saying delete it from discussion of the impact of policy on aggregate demand.
Philo
Dec 20 2023 at 9:10pm
. . . because, while it matters in some respects, it does not matter for aggregate demand.
spencer
Dec 21 2023 at 7:23am
The financialization of the economy makes N-gDp a more important target. More funds today involve the transfer of title or claims thereto, creating a leakage in the circular flow of income.
Thomas L Hutcheson
Dec 21 2023 at 4:17pm
Strictly speaking, I agree. The Fed handles inflation and disinflation, total employment and unemployment in such a way as to maximize real income. The President and Congress handle real income maximization and income distribution.
However, in following a real income maximization strategy, during a recession more spending will pass a NPV>0 test when there are unemployed resources (some marginal costs will be less than market prices) and borrowing rates over the time period relevant for the expenditure are lower than when the FEd is not trying to increase inflation.
This combination of both the Fed and fiscal policy maximizing real income will look like “Keynesian” fiscal policy.
Ahmed Fares
Dec 23 2023 at 8:38pm
An article from Tim Worstall about the monetary offset with credit to Scott Sumner (emphasis mine):
https://www.washingtonexaminer.com/opinion/the-fed-didnt-raise-interest-rates-to-annoy-trump-they-did-it-because-of-tax-cuts
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