Optimal Monetary and Fiscal Policy during Economic Decline
March 23, 2011
A new research paper by N. Gregory Mankiw, a professor of economics at Harvard University, and Matthew Weinzierl, an assistant professor at Harvard University, explores the optimal monetary and fiscal policy for an economy experiencing a shortfall in aggregate demand. Their model is simple enough to be tractable yet rich enough to offer some useful guidelines for policymakers, according to Mankiw and Weinzierl.
One clear implication of the analysis is that how any policy is used depends on which other policy instruments are available. It is fair to say that there is a hierarchy of instruments for policymakers to take off the shelf when the economy has insufficient aggregate demand to maintain full employment of its productive resources.
The first level of the hierarchy applies when the economy does not face the zero lower bound for nominal interest rates.
- In this case, conventional monetary policy is sufficient to restore the economy to full employment.
- That is, all that is needed is for the central bank to cut the short-term interest rate.
The second level of the hierarchy applies when the short-term interest rate hits against the zero lower bound.
- In this case, unconventional monetary policy becomes the next policy instrument to be used to restore full employment.
- A reduction in long-term interest rates may be sufficient when a cut in the short-term interest rate is not.
The third level of the hierarchy is reached when monetary policy is severely constrained.
- In this case, fiscal policy may play a role.
- Fiscal policy should aim at incentivizing interest-sensitive components of spending, such as investment.
The fourth level of the hierarchy is reached when monetary policy is severely constrained and fiscal policymakers rely on only a limited set of fiscal tools. If targeted tax policy is for some reason unavailable, then policymakers may want expand aggregate demand by increasing government spending, as well as cutting the overall level of taxation to encourage consumption, say Mankiw and Weinzierl.
Source: N. Gregory Mankiw and Matthew Weinzierl, "An Exploration of Optimal Stabilization Policy," Harvard University, March 8, 2011.
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