Arnold Kling  

Clive Crook on Monetary Policy

The Age of Government Dependen... 10:1...

He writes,

The past few weeks have settled, to my satisfaction at least, a long-running debate on this very topic. Rather than targeting inflation, central banks should keep nominal incomes growing on a pre-announced path: say 5 per cent a year.

Pointer from Scott Sumner, who of course has advocated something along these lines for quite some time. My thoughts:

1. According to textbook macro, inflation can always accomplish the same thing as fiscal stimulus. In fact, there is no macroeconomic model which says both that deficit spending is expansionary and higher inflation is not. This is a point of economic theory that is not understood by the public.

2. The central bank can always cause inflation if it wants to.

Point (2) should be uncontroversial. However, the idea of a "liquidity trap," if it means anything, means that the central bank cannot cause inflation if it wants to. When someone says that we are in a liquidity trap or the Fed is out of ammunition, they should be obliged to defend the proposition that the central bank can no longer cause inflation, even if it wants to.

Pundits who advocate for fiscal stimulus rely on the public's ignorance of point (1) to make their case with laymen. To make their case with economists, they rely on creating fear and doubt about point (2). They don't convince anyone with logic, but sometimes sheer repetition and contemptuous bullying do the trick.

Together, points (1) and (2) imply that fiscal stimulus is not necessary in order to increase aggregate demand.

3. It could be that aggregate demand is not the main factor in our current troubles. See my posts on PSST.

4. It also could be that inflation cannot be fine tuned. That is, when inflation starts to rise, the public takes steps to economize on the use of money, which causes velocity to rise. Thus, there are two regimes--one with low and steady inflation; and one with high and volatile inflation. An inflation rate in the range of, say, 4 to 8 percent, is not stable. Once you get above 4 percent, you either have to squeeze inflation out altogether or watch it rise toward double digits. I have argued for this two-regime story in the past, and I continue to think it has some validity.

If (3) and (4) are correct, then monetary expansion may have adverse results. It will not increase employment by much, and it may push us into the high-inflation regime.

All of this said, I would like to see monetary expansion tried. The probability that (3) is correct is not 100 percent, and the probability that the textbook model of AS-AD is correct is not zero. Given the severity of the unemployment situation, monetary expansion is worth a try, in my opinion.

The simplest approach to monetary expansion would be for the Fed to stop paying interest on reserves. However, in addition, the Fed could purchase more assets.

Comments and Sharing

COMMENTS (8 to date)
Effem writes:

I don't think it's enough to probability-weight the chances of success. I think we also need to probability-weight the potential costs of failure. If we are wrong about easing being a positive and; in fact, it contributes to the wrong type of inflation (food & energy) thus reducing real wealth for the majority of the population, then I think we run the risk of social unrest and losing reserve currency status.

How do we properly assess small (?) risks of disastrous outcomes? The focus on most-likely outcomes strikes me as short-sighted for such important matters.

Daniel Molling writes:

I've been waiting for this post for a long time This is a great summary of the role of stimulus in economic models, thanks.

OneEyedMan writes:

You wouldn't think it would be difficult to convince creditors that the central bank was serious about harming their investments but apparently it is. American and Japanese central bankers seem to have spent so much effort convincing us that they abhor inflation that creditors no longer think threats of higher inflation are credible.

Bryan Willman writes:

A free central bank can always cause inflation if it wants to, BUT:

It may not be able to use channels of monetary policy it has used in the past. So for example, rather than adding to the monetary base by buying securities, it might have to do some more radical thing like mailing currency to households. Or offering to buy every used car in America for 1.25x the blue book price, and then crushing most of them. It might require a new and radical channel, but they can create inflation.

I find the claims of people who argue that fiscal stimulus can be had while reducing a deficit, or that fiscal and monetary stimulus are somehow profoundly different, to be baffling. Arnold now suggests that some of these claims are simply dishonest - I shall remember that.

AC writes:

And yet a large percentage of economists advocate fiscal stimulus in a recession, even without arguing for a liquidity trap. Why? (Besides advocating for specific spending programs that they like)

Shayne Cook writes:

following the Bryan Willman comment above ...

The Fed, and its ability to effect monetary expansion, has a very distinct and limiting problem - it cannot control, or even influence to any great degree, how/where its 'monetary expansion' would flow. The Federal Government regulatory policy (social engineering) does that. Even Willman's suggestions of mailing currency/buying cars would be stomped on by Federal Government as an invasion of their exclusive right to "guide" spending in the U.S.

Thus, Fed monetary expansion - within the U.S. - could not drive general inflation. It would only drive asset "bubbles", such as the recent housing bubble. Or, it would be deployed as investment spending outside the U.S.

As long as the Federal Government, via (social engineering) tax/regulatory policy, insists on guiding money flows exclusively to housing, health care, education and ultra-expensive energy experiments, while simultaneously penalizing all other investments, the U.S. will have "bubbles", not general inflation.

Philo writes:

"An inflation rate in the range of, say, 4 to 8 percent, is not stable. Once you get above 4 percent, you either have to squeeze inflation out altogether or watch it rise toward double digits. I have argued for this two-regime story in the past . . . ."

What's the argument? Why should there be a discontinuity at ("say"!) 4 percent? (Where did you get that number? And what happens above 8 percent: wouldn't you say that a rate of inflation in the range of 8 to 1,000,000 percent was not stable? And does "not stable" mean "increases without bound"--regardless of any measures taken by the central bank--or might the rate sometimes sharply *decrease*? [But why would it do that?])

You grant that if inflation is 0 percent the central bank can cause it to increase to 3 percent, and stay there ("be stable"). Then if inflation is 3 percent, why could not the central bank, through similar measures, cause the rate to increase to 6 percent *and stay there*?

Philo writes:

Christina Romer on recalculation: "Because nearly 10 million men of prime working age were drafted into the military [in WWII], there was a huge skills gap between the jobs that needed to be done on the home front and the remaining work force. Yet businesses and workers found a way to get the job done. Factories simplified production methods and housewives learned to rivet. Here the lesson is that demand is crucial — and that jobs don’t go unfilled for long. If jobs were widely available today, unemployed workers would quickly find a way to acquire needed skills or move to where the jobs were located." (

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