Since the 1970's, one of the main controversies in macroeconomics has been whether nominal variables affect real variables. A classic example: Does the inflation rate (a nominal variable) affect employment (a real variable)? The answer that emerged from this debate is that nominal variables DO affect real variables, but with a long list of caveats, such as:
1. The benefits are usually transitory, and the costs are often lingering. Using inflation to reduce unemployment works for a while, but in a couple years unemployment is back where it would have been, and inflation remains higher.
2. The more frequently and aggressively you use nominal variables to affect real variables, the less it works. In a country where the government has never raised inflation to cut unemployment, it is likely to be successful. In countries where using inflation to fight unemployment is second nature, it often fails.
One argument that has been largely forgotten after this protracted debate is what determines nominal variables in the first place. It is obvious to everyone (except Fischer Black) that a government with a printing press can affect nominal variables. Change the quantity of money, and the quantity of spending changes too.
But what about fiscal policy - taxes and government spending? Again, it seems obvious to almost everyone that these matter too. But I have long been skeptical. I keep asking: Where does the money come from? If the central bank prints up $1000 and the government uses it to cut taxes, spending goes up; but that is monetary policy in disguise. The interesting question is: What if you raise spending (or cut taxes) and hold the quantity of money constant? The basic possibilities:
1. You raise spending by raising taxes. This seems like a wash for total spending. (There is a sophistical argument about the Keynesian multiplier that says otherwise, but I won't bother with it here).
2. You raise spending by borrowing. Again, this seems like a wash for total spending. If the quantity of loanable funds stays the same, the government borrows more and the private sector borrows less. If the quantity of loanable funds goes up because of higher interest rates, the government borrows more and the private sector consumes less.
3. You raise spending by printing money. Oh, wait, we ruled this out by assumption.
I'm glossing over a lot of complexities here, but at least it should no longer be obvious that fiscal policy affects nominal variables, holding the money supply constant. Once we see it's not obvious, then we can flip the presumption and start wondering how it's possible for fiscal policy to affect nominal variables. There are two leading mechanisms:
1. As interest rates go up, the quantity of money that people want to hold falls. If interest rates are 3%, holding $100 in your wallet for a year costs $3; if interest rates are 5%, holding $100 costs $5. The higher the price of holding money, the less people want to hold.
When interest rates go up, then, people attempt to reduce their cash holdings. Holding the money supply constant, of course, that's impossible, because every dollar has an owner. But the effect in equilibrium is that nominal income rises so much that people are once again content with holding the quantity of money that exists.
The main weakness in this mechanism is that I have never met anyone who has adjusted his cash holdings when the interest rate changed. Before I studied economics, it never occured to me that I should. Most economists I've polled admit that their cash holdings do not respond to interest rates, and I'm confident that non-economists are even less responsive.
Admittedly, if interest rates rose to 30%, a lot of unresponsive people would start responding. But within the range people experience in Western countries, the interest-elasticity of money demand is probably around zero. (Maybe institutional investors give money demand a little elasticity, though even there, I doubt it's much). Once again, then, it looks like fiscal policy doesn't matter for nominal variables.
For you intermediate Keynesian macro junkies, my claim is the vertical LM curve is not a theoretical curiosity; it's probably close to the truth.
2. What's left? Central banks rarely set quantity targets; instead, they typically set interest rates. Same difference, right? Not quite.
Suppose a central bank sets an interest rate of 3%, and the government raises spending by borrowing. What happens? In order to keep the interest rate from rising, the central bank must increase the money supply! As a result, bigger deficits increase nominal variables because deficits cause the money supply to increase.
A nice example: Textbooks still cite WWII as proof of the power of fiscal policy. But what would have happened to interest rates if the Fed had kept the money supply constant while the federal government borrowed to the hilt? Rates would have skyrocketed, choking off private investment and consumption.
Why then did deficit spending appear to have a powerful effect on total spending during the war? Because the Fed set a 1% interest rate and kept the printing presses running full speed to keep it there. From January 1942 to January 1946, the monetary base expanded by 79%.
The lesson: If an average student has a genius willing to take his SAT for him, an average student can get a perfect score on the SAT. Similarly, if the central bank is willing to monetize deficits, then deficit spending affects nominal variables. Both statements are literally correct, but obscure the deeper truths: Unaided, average students get average scores on the SAT, and fiscal policy has little effect on nominal variables.