Here is an excerpt from my latest paper for the Mercatus Center.
What role does this leave for fiscal policy? What would an effective fiscal stimulus look like? It turns out that fiscal policy could play a role, but only through supply-side channels. Return to the AS/AD diagram discussed above. If policymakers were able to increase aggregate supply, then the Fed would be under no pressure to offset the effects with tighter monetary policy. That’s because supply-side tax cuts actually tend to lower the inflation rates and raise growth. A good example is a cut in the employer-side of the payroll tax, which would encourage hiring but would not boost wages or prices. Indeed, the cost of labor from the firm’s perspective would decline, whereas workers would see no change in take-home pay. Some economists believe that cuts in taxes on investment income might also boost aggregate supply.
Policy is most effective if each part of the government focuses on what it does best. That means the Fed should focus on stable monetary conditions. Elsewhere I’ve argued that this can best be achieved by targeting a stable growth path for nominal GDP.14 By committing to a policy of stable spending growth, the Fed can shape market expectations in a way that would lessen the volatility created by its current policies. This would result in less aggressive policies from the Fed in the long run. Meanwhile, the fiscal authorities should focus on the supply side of the economy, creating an environment where the private sector can flourish. Attempts to jumpstart the economy with demand-side fiscal stimulus merely cause the government to pile up more debt, with any growth effects being offset by the Fed.