Bryan Caplan  

Blogging Billiards: A Fiscal Policy Trick Shot?

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Two weeks ago I emailed Mankiw a question about fiscal policy, referencing one of my previous posts.

Mankiw replied (June 7).

Then Brad DeLong responded to Mankiw (on June 15, updated June 17).

DeLong's post in turn apparently provoked a note from Paul Krugman, which DeLong posted (June 17).

Email from me provokes a response from Krugman via DeLong via Mankiw... that's what I call a blogging trick shot!

DeLong/Krugman interestingly agree with my conclusion that fiscal policy has no effect on nominal GDP, but our suggested mechanisms are very different.

My guess is that fiscal expansions have roughly zero effect as long as the Fed raises interest rates enough to keep the money supply from expanding.

The DeLong/Krugman view is that, at least these days, fiscal expansions have roughly zero effect because the Fed raises interest rates MORE than enough to keep the money supply from expanding in response. In other words, fiscal expansions now provoke monetary contractions.

Who's right? Most of the evidence that DeLong/Krugman could marshall for their view also fits mine. If the Fed wants to make inflation 2%, then DeLong/Krugman predict that the Fed will respond to fiscal expansions with higher interest rates. Given an inflation target, that's my prediction, too. Admittedly, DeLong/Krugman predict that the Fed has to contract the money supply relative to its previously intended path, while I just predict that the Fed has to keep the money supply from increasing relative to its previously intended path. But it's hard to know what the Fed's intended path for the money supply was. We never see what the Fed would have done if fiscal policy had been different.

The simplest way I can think of to race these two theories of fiscal impotence is to look at the impact of fiscal policy on nominal GDP when the central bank is run by dogmatic monetarists. I say fiscal policy won't matter; DeLong/Krugman say it will. But alas, dogmatic monetatists in positions of power have always been very scarce, and as far as I've heard are now virtually non-existent.

Other ideas for how to settle this dispute?


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COMMENTS (5 to date)
Matt writes:

The economy seeks equilibrium between the relative sizes of the private and public sectors, a result predicted when purchases of goverment services are 'en mass' rather than pay as you go.

Hence, according to my amateur economics science, the private sector expands in response to public sector expansion. The expansion is generally not productivity expansion, unless the government is adding productivity to the mix. The expansion is generally linear sprawl, driven by low wage immigrants. Simple linear expansion of the economy, which helps no one, requires expansion of the money supply.

m writes:

I forgot to mention.

Debt funding of government happens when taxes are flattened, because the main purchasers of government services see a higher rate of return from goverment services. Hence, goverment expands with debt funding because there is no one in authority paying the bills.

Government operations act like a very, very sticky free market, but it obeys, ultimately, free market principles of pricing.

John T. Kennedy writes:
Other ideas for how to settle this dispute?

Pistols at ten paces.

spencer writes:

Through the keysenian impact on consumption fiscal policy will impact how rapidly the economy
rebounds from a recession to regain the ceiling the fed is imposing on nominal gdp growth and/or inflation relative to its long term trend or potential gdp.

Fiscal policy can have a cyclical impact but not a secular impact.

Brad DeLong writes:

Well, it is an interesting and important question that everyone thinks about...

I think part of the answer depends on what your definition of "money" is. The broader the definition of money, then with dogmatic monetarists in control the closer the LM curve is to being vertical. A central bank that sees its mission as being that of targeting, as John Taylor once said, "velocity-adjusted M3" will produce a zero fiscal multiplier. A central bank that is targeting the monetary base will produce somewhat of a fiscal multiplier...

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