Grasping Reality on TypePad, by Brad DeLong

Paul Krugman writes:

Getting Nominal: “Market monetarists” like Scott Sumner and David Beckworth are crowing about the new respectability of nominal GDP targeting. And they have a right to be happy. My beef with market monetarism early on was that its proponents seemed to be saying that the Fed could always hit whatever nominal GDP level it wanted; this seemed to me to vastly underrate the problems caused by a liquidity trap. My view was always that the only way the Fed could be assured of getting traction was via expectations, especially expectations of higher inflation –a view that went all the way back to my early stuff on Japan. And I didn’t think the climate was ripe for that kind of inflation-creating exercise.

At this point, however, we seem to have a broad convergence. As I read them, the market monetarists have largely moved to an expectations view. And now that we’re almost four years into the Lesser Depression, I’m willing, out of a combination of a sense that support is building for a Fed regime shift and sheer desperation, to support the use of expectations-based monetary policy as our best hope.

And one thing the market monetarists may have been right about is the usefulness of focusing on nominal GDP. As far as I can see,the underlying economics is about expected inflation; but stating the goal in terms of nominal GDP may nonetheless be a good idea, largely as a selling point, since it (a) is easier to make the case that we’ve fallen far below where we should be and (b) doesn’t sound so scary and anti-social.

I still believe that the chances of success will be a lot larger if we have expansionary fiscal policy too; but by all means let’s try whatever we can…

Let's try to answer this question by using… the IS-LM model!

If you are--as we are right now--in a liquidity trap, with extremely interest-elastic money demand, then expansionary monetary policy that involved the Federal Reserve buying financial assets for cash:

1. will have next to no effect on the short-term safe nominal interest rate--it's already zero.
2. will decrease the long-term safe nominal interest rate to the extent that your open-market operations today change people's expectations of what your target for the short-term safe nominal interest rate in the future.
3. will decrease the long-term safe real interest rate to the extent that it decreases the short-term nominal interest rate and changes expectations today of what inflation will be in the future.
4. will decrease the long-term risky real interest rate to the extent that it decreases the long-term safe real interest rate and to the extent that the assets purchased for cash by the Federal Reserve free up the risk-bearing capacity of private investors and lead to a reduction in risk spreads.
5. will increase spending to the extent that it decreases the long-term risky real interest rate and to the extent that private spending responds positively to decreases in the long-term risky real interest rate.

Lots of steps here, some of which may well be weak.

By contrast, the alternative expansionary policy is for the government to print money and spend it buying useful things. Then:

1. The buying of useful things raises spending.
2. Financing it by printing money rather than issuing bonds means no increase in interest rates to crowd out private spending.
3. Financing it by printing money rather than promising to levy future taxes means no increase in the present value of future tax liability to crowd out private spending.
4. Financing it by printing money means no worries about any increase in fears of some future government default.

By contrast, if we tried to target nominal GDP through fiscal policy alone--through borrowing and spending buying useful things:

1. The buying of useful things raises spending.
2. Financing it by issuing bonds might mean an increase in interest rates that would crowd out private spending.
3. Financing it by promising to levy future taxes means an increase in the present value of future tax liability that might crowd out private spending.
4. Financing it by issuing bonds means a possible increase in fears of some future government default.

To try to target nominal GDP using either only monetary policy or only fiscal policy seems hazardous. To coordinate--monetary and fiscal expansion, money printing-financed purchase of useful things--seems to be the winner.