One criticism of using monetary stimulus at the zero bound is that the effects depend on a commitment to do something in the future, which might not be credible. I happen to think that’s always true of monetary policy, so I don’t find the argument persuasive. But most people disagree with me. Nick Rowe has an excellent post showing that fiscal policymakers face exactly the same credibility problem:
OK, so what about a temporary increase in G? Won’t that shift the New Keynesian IS curve upwards, and cause the natural rate of interest to increase temporarily? Yes and no. If you increase G from 200 to 300 today, and promise to reduce it from 300 to 200 tomorrow, that will increase AD today. But if you leave G at 200 today, and promise to reduce it from 200 to 100 tomorrow, that will have exactly the same effect on AD today. Today’s increase in G is not what causes AD to increase. It’s tomorrow’s decrease in G that causes today’s AD to increase.
Here’s the intuition. A temporary increase in G from 200 to 300 and back to 200 is identical to a permanent increase of G from 200 to 300 plus a promise to cut G by 100 tomorrow. We have already established that a permanent increase in G does nothing. Therefore the effect of a temporary increase in G is identical to the effect of a promise to cut G in future.
A decrease in future G (once the economy has escaped the ZLB) causes an equivalent increase in future C. By consumption-smoothing, that increase in future C causes an equivalent increase in current C, for a given real interest rate between today and the future.
OK. Now let’s compare monetary policy to fiscal policy at the ZLB. We can either promise to loosen future monetary policy. Or we can promise to cut future government spending. Which promise is more credible?
Hmmmmm. The answer’s not so obvious, is it?
Notice something weird? I have made absolutely no change in the standard New Keynesian model. The only thing I have done is to re-frame the question. Instead of talking about the effects of a temporary increase in government spending I am talking about the effects of a promise to cut future government spending.
I have changed the definition of “doing nothing“. Under the original definition, we do something now, when we increase government spending, and we do nothing in the future, when government spending just falls again, all by its little self. Under my re-definition of “doing nothing“, we do nothing now, and we promise to do something in the future, when we will actively cut government spending.
Acts of commission and ommission. Trolley problems. Stuff like that. That’s what we are talking about.
By changing the definition of “doing nothing” I have suddenly made both fical and monetary policy at the ZLB rely on the credibility of promises of future actions. The two policies are now on a par.
Now I’m going to go further, and change the definition of “doing nothing” with monetary policy.
Take the standard New Keynesian macro model, and bolt on a bog-standard money demand function. You can even make that money demand function perfectly interest-elastic at the ZLB, if you like.
It is well-understood by New Keynesian macroeconomists that if you add a money demand function it does nothing whatsoever to the model. The two models are observationally equivalent. For every interest rate reaction function there exists a money supply reaction function, and vice versa. But it lets me change the definition of “doing nothing“.
Again, a credible promise to keep future interest rates too low for too long will increase the expected future price level. That means the future nominal demand for money will be higher too. In equilibrium, money supply equals money demand, so the expected future money supply will be higher too.
A permanent increase in the money supply today is equivalent to a promise to keep future interest rates too low for too long.
Let’s see how the question looks now. The New Keynesians are asking us to believe that a promise to cut future government spending would be more credible than an actual increase in the money supply today. Really?
See how I have turned the tables, just by redefining what “doing nothing” means? All of a sudden it is fiscal policy that requires credibility of a promise of future action. Monetary policy simply requires a belief that central bank will “do nothing” in future. It won’t decrease the money supply back down again.
Roosevelt was at the ZLB. He didn’t promise to keep interest rates too low for too long. Roosevelt simply raised the price of gold. And it worked. Because people naturally assumed he would “do nothing” in future. By “doing nothing” they understood “not lowering the price of gold back down again”. It worked because people thought of “monetary policy” as “setting the price of gold”.
New Keynesian macroeconomists will be tempted to insist that monetary policy really is, is, IS, IS setting interest rates. Any monetarist could insist right back that monetary policy really is, is, IS, IS setting the money supply. And a gold bug could in turn insist that monetary policy really is, is, IS, IS setting the price of gold. That argument will get us nowhere. Nor will arguing over whether fiscal policy really is setting the level of government spending or setting the change in government spending.
It’s all in the framing. There is no reality in these matters. These are all social constructions of reality. We theorists shouldn’t be suckered into believing that our conceptual schemes are out there in the real world. Except, the conceptual schemes of real people out there in the real world are part of the reality of that world, for a social scientist. And the Neo-Wicksellian social construction of reality, in which “monetary policy” is defined as “setting interest rates”, is a damned bad reality to construct. Especially when we hit the ZLB.
A few comments:
1. I like to see Nick Rowe get post-modern.
2. I agree about the social construction of reality. Nevertheless I’d like to convince people that monetary policy really is, is, IS, IS the control of NGDP expectations. Not because it really is, but rather because no matter what monetary policymakers claim they care about, NGDP really is, is, IS, IS what they care about. So it’s the logical way of thinking about policy.
3. We are an NGDP futures market away from blowing interest rate-oriented monetary theory right out of the water. Once you start targeting NGDP futures, the fed funds rate becomes about as interesting as the price of a bushel of pistachio nuts.
And then reporters can ask Bernanke; “How will your forecast of NGDP two years out change if Congress fails to renew the payroll tax cut, and WHY WILL IT CHANGE?”
PS. My personal favorite among my posts was about framing affects, although it was quite different from Nick’s post.