A friend on Twitter * asked me about my claim that the precise level of unemployment consistent with “full” employment is important for monetary policy, but is not important to the argument against doing fiscal stimulus in the current environment.
So long as the economy is out of liquidity trap and within range ** of full employment (as seems reliably to apply now), there is no case for fiscal stimulus, at least on aggregate demand grounds. It would systematically be offset by monetary policy.
But isn’t that a contradiction? If the possibility of remaining slack is influencing the Fed, then why should it not also influence the case for fiscal stimulus?
Basically, the reason is that the Fed acts second and takes fiscal policy into account. Here is Simon Wren-Lewis on the issue. This is not so simply because Wren-Lewis says it is. (I think he is terribly wrong about h money, for example.) But, fwiw, I happen to agree with him on this:
There are clear grounds for saying that the Fed is wrong about the economy being close to full employment, and therefore any increase in aggregate demand from any source would not raise inflation. But a central bank that acts in the textbook manner will not wait for the higher inflation to materialise, but will anticipate it because it takes time for interest rates to influence demand and inflation. As a result, tax cuts will lead to higher interest rates and there will be no net impact on demand.
I suspect that the market for my post here is about one person, especially if you net out the people who will just complain that this is a model-dependent take, unlike theirs! So I will leave it pretty much at what Wren-Lewis says.
I would just add that to a first approximation a useful role for fiscal policy in aggregate demand management disappears as soon as the Fed finds itself in a position where it is no longer delivering as much aggregate demand as is plausible, and believing itself to be coming up short. Once the Fed shifts to calibrating its stimulus or restraint, the role for fiscal policy is over, at least temporarily.
Incidentally, it is under those same conditions that monetary policy becomes “data dependent”, a term that really confused the hell out of people. I think that is a fun aside, but it is an aside.
There is also the issue of how a larger deficit might durably raise the equilibrium interest rate and prevent the Fed from suffering a return to liquidity trap later in the cycle. In my view, a larger deficit would not do that durably, as Japan’s experience exemplifies, even if it were to be sustained, which I certainly would not trust with this Congress. But that too is an aside. So I stop here.
I hope this helped, you one guy.
* You have at worst a 1 in 8 chance of guessing who it is.
** I keep that term intentionally loose, but I guess the window would be the horizon over which the Fed expects monetary policy to have influence. The influences builds and fades, so I guess there is no one horizon, defined in black and white.