2 MERCATUS ON POLICY SEPTEMBER 2013
Why has the effect of scal stimulus been so meager in recent years? After all, interest rates in the United States have beenclose to zero since the end of 2008. The most likely explana-tion is
, a concept built into modern central bank policy but poorly understood. We can visualize mone-tary offset with the Keynesian aggregate supply and demanddiagram used in introductory economics textbooks. If scalstimulus works, it’s by shifting the aggregate demand (AD)curve to the right. This tends to raise both prices and outputas the economy moves from point A to point B, although inthe very long run, only prices are affected.Now let’s assume that the central bank is targeting ina-tion at 2 percent. If scal stimulus shifts the AD curve tothe right, then prices will tend to rise. The central bankthen must adopt a more contractionary monetary policy inorder to prevent ination from exceeding their 2 percenttarget. The contractionary monetary policy shifts AD backto the left, offsetting the effect of the scal stimulus. Thisis called
.By the 1990s this process was pretty well understood,which is why even many of the so-called New Keynesianeconomists began to lose interest in scal policy as a sta- bilization tool.
Instead, the focus shifted to central bankpolicy, and elaborate rules were devised to assist the cen-tral bank in steering the economy toward low ination andstable growth. Perhaps the most famous was the TaylorRule, which called for central banks to adjust interest ratesso as to keep ination near 2 percent and output close topotential output.
If the central bank is steering the economy or, more pre-cisely, nominal aggregates, such as ination and nominalGDP, then scal policy would be unable to impact aggre-gate demand. As an analogy, imagine a child attempting toturn the steering wheel of a car. The parent might respond by gripping the wheel even tighter, offsetting the push of the child. Even though the child’s actions would initially change the direction of the car, ceteris paribus, the parentwill push back with equal force and correct this turn tokeep the car on the road.If monetary offset was well understood by the 1990s,why was there so much support for scal stimulus in therecent recession? It seems that many economists wrongly assumed that the normal monetary offset model no longerheld, due to three misconceptions:1. In early 2009 many economists wrongly assumedthat the Fed was out of ammunition, leaving mon-etary policy adrift, or passive.
2. Some economists have told me that the Fed wouldnever attempt to sabotage scal stimulus becausethe Fed also wanted to see a robust recovery.3. Fed ofcials like Ben Bernanke occasionally spokeout against scal austerity, making monetary offsetseem even less likely.
By now we know that central banks are not out of policy options when rates fall to zero.
And, in a sense, this nevershould have been in doubt. When Japanese interest rateshit zero in the late 1990s, Ben Bernanke (then an academic)dismissed arguments that policy is ineffective at the zero bound.
So did Milton Friedman.
The best-selling mon-etary economics textbook of 2010, written by former Fedofficial Frederic Mishkin, noted that monetary policy remains “highly effective” when short term rates fall closeto zero.
We’ve recently seen the Bank of Japan engineera sharp depreciation of the yen, despite near zero interestrates. This contradicts Keynesian “liquidity trap” models,which suggest that central banks are unable to depreciatetheir currencies once short-term rates fall to zero. It’s safeto say that the “out of ammunition” view of monetary inef-fectiveness has been thoroughly discredited.The other two objections to monetary offset are harderto dismiss. The Fed has been disappointed by the pace of recovery and wishes that aggregate demand had risen at afaster pace over the past ve years. This remains the cen-tral reason why most Keynesians continue to favor scalstimulus. But on closer inspection it seems quite likely thatthe Fed has been sabotaging scal stimulus (and offsetting recent austerity), perhaps without even realizing it.