Hoisted from the Archives: Evaluating Fiscal Stimulus
Quote of the Day: October 25, 2011

A Note on Fiscal Policy in a Depressed Economy

Since the mid-eighteenth century, economists have recognized that changes in the pace at which economic agents spend induce changes in the level of prices and in the flow of production. We see this as early as David Hume's 1742 essay "On the Balance of Trade" http://tinyurl.com/dl20110902a. In Hume (1742), changes in the economic environment or in economic policy--an import of gold resulting from a trade surplus or a financial reform that makes it easier for banks to accept deposits--that generates a change in in private agents' money holdings induces them to change the pace at which they spend, which then affects the level of prices and the pace of production.

Starting from this perspective, whether expansionary government fiscal policy would expand the nominal flow--and in a sticky-price world the real flow of spending--has an obvious answer: yes, it would. Expansionary monetary policy works by increasing the money stock and reducing interest rates, and so inducing economic agents to increase the pace at which they spend. Expansionary fiscal policy induces one very large economic agent--the government--to increase the pace at which it spends.

In this respect, at least the government's spending is as good as anybody else's spending.

Thus any economist who holds that expansionary monetary policy has real (or even nominal) effects is thereby committed to presuming that expansionary fiscal policy has similar effects as well.

In spite of this, only five years ago the majority of policy-oriented mainstream American economists, if asked whether fiscal policy had a role to play in stabilization policy, would have said that it did not--or that it had at most a very small role. Perhaps, they would have said, the automatic stabilizers built into the tax-and-transfer system were useful. But, they would have said, fiscal policy had no other stabilization policy role to play. Fiscal policy, they would have said, should focus on the long-run issues of ensuring confidence in intertemporal budget balance and rightsizing the public sector. Monetary policy can carry out the stabilization policy mission, we thought. And monetary policy should do so: it has a comparative advantage, we thought.

How differently do we think today? And to what extent is our difference in thought a loss of confidence in the institutional competence of the Federal Reserve, and to what extent is it a shift in our understanding of how the macroeconomy works (at least in extreme circumstances) that would affect our thinking even if we still had full confidence in the Federal Reserve?