I don't think Simon Wren-Lewis will find this an annoying argument against fiscal policy. I hope not anyway.
Let's assume that New Keynesian macroeconomics is 100% correct. What role is there for fiscal policy?
Simon agrees that in normal times there is no role for fiscal policy as a tool to control Aggregate Demand. Monetary policy can handle AD all by itself. Fiscal policy has a lot of micro jobs to do: making sure the right number of bridges get built at the right time in the right places; and making sure that the right people are taxed the right amount at the right time for allocative efficiency and equity. It would be suboptimal to distract fiscal policy from its microeconomic job and leave monetary policy less than fully employed at doing its macroeconomic job.
The New Keynesian case for fiscal policy as a tool to influence AD only applies at the Zero Lower Bound, when monetary policy is supposedly incapable of doing the job by itself. Let's concentrate on that ZLB case.
Even New Keynesian macroeconomists recognise that a commitment to future monetary policy can still be effective at the ZLB. The central bank promises that in future it will leave interest rates "too low for too long". So, why can't we say that monetary policy still works, even at the ZLB? Their reply is that such a promise might not be credible. OK. Let's grant them that assumption. Promises about future monetary policy are assumed not credible.
New Keynesian macroeconomists say that increases in government spending will increase AD when the economy is at the ZLB. That isn't quite right. In fact, it's wrong. That is not what their models actually say.
Let's take this bit slowly. First consider a permanent increase in government spending in a New Keynesian model. The result is no change in the natural rate of interest. The New Keynesian IS curve does not shift vertically up when there is a permanent increase in G. For a given time-path of Y (remember, we are asking if the IS curve shifts vertically up, not horizontally right, so this is a legitimate supposition) a permanent increase of G and a permanent decrease of C by an equal amount will leave the consumption-Euler equation still satisfied at the original time-path of real interest rates. Intuitively, a permanent increase in G means an equivalent reduction in permanent disposable income and an equivalent reduction in desired consumption. (New Keynesian macroeconomists may miss seeing this if they ask whether an increase in G shifts the IS curve right, as opposed to shifting it up. But if you put permanent income on the horizontal axis, the New Keynesian IS curve is horizontal, so it makes no sense to ask whether a permanent increase in G will shift that horizontal IS curve rightwards.)
(The only effect of a permanent increase in G in a New Keynesian model comes through the supply-side. If the government takes part of national income and spends it on (say) pyramids (which is what New Keynesian models typically assume, since G does not appear in the representative agent's utility function), then the representative agent may choose to work more hours, because he is now poorer. But this supply-side effect is not what New Keynesians need if they want to prevent deflation at the ZLB. It only makes things worse.)
OK, so what about a temporary increase in G? Won't that shift the New Keynesian IS curve upwards, and cause the natural rate of interest to increase temporarily? Yes and no. If you increase G from 200 to 300 today, and promise to reduce it from 300 to 200 tomorrow, that will increase AD today. But if you leave G at 200 today, and promise to reduce it from 200 to 100 tomorrow, that will have exactly the same effect on AD today. Today's increase in G is not what causes AD to increase. It's tomorrow's decrease in G that causes today's AD to increase.
Here's the intuition. A temporary increase in G from 200 to 300 and back to 200 is identical to a permanent increase of G from 200 to 300 plus a promise to cut G by 100 tomorrow. We have already established that a permanent increase in G does nothing. Therefore the effect of a temporary increase in G is identical to the effect of a promise to cut G in future.
A decrease in future G (once the economy has escaped the ZLB) causes an equivalent increase in future C. By consumption-smoothing, that increase in future C causes an equivalent increase in current C, for a given real interest rate between today and the future.
OK. Now let's compare monetary policy to fiscal policy at the ZLB. We can either promise to loosen future monetary policy. Or we can promise to cut future government spending. Which promise is more credible?
Hmmmmm. The answer's not so obvious, is it?
Notice something weird? I have made absolutely no change in the standard New Keynesian model. The only thing I have done is to re-frame the question. Instead of talking about the effects of a temporary increase in government spending I am talking about the effects of a promise to cut future government spending.
I have changed the definition of "doing nothing". Under the original definition, we do something now, when we increase government spending, and we do nothing in the future, when government spending just falls again, all by its little self. Under my re-definition of "doing nothing", we do nothing now, and we promise to do something in the future, when we will actively cut government spending.
Acts of commission and ommission. Trolley problems. Stuff like that. That's what we are talking about.
By changing the definition of "doing nothing" I have suddenly made both fical and monetary policy at the ZLB rely on the credibility of promises of future actions. The two policies are now on a par.
Now I'm going to go further, and change the definition of "doing nothing" with monetary policy.
Take the standard New Keynesian macro model, and bolt on a bog-standard money demand function. You can even make that money demand function perfectly interest-elastic at the ZLB, if you like.
It is well-understood by New Keynesian macroeconomists that if you add a money demand function it does nothing whatsoever to the model. The two models are observationally equivalent. For every interest rate reaction function there exists a money supply reaction function, and vice versa. But it lets me change the definition of "doing nothing".
Again, a credible promise to keep future interest rates too low for too long will increase the expected future price level. That means the future nominal demand for money will be higher too. In equilibrium, money supply equals money demand, so the expected future money supply will be higher too.
A permanent increase in the money supply today is equivalent to a promise to keep future interest rates too low for too long.
Let's see how the question looks now. The New Keynesians are asking us to believe that a promise to cut future government spending would be more credible than an actual increase in the money supply today. Really?
See how I have turned the tables, just by redefining what "doing nothing" means? All of a sudden it is fiscal policy that requires credibility of a promise of future action. Monetary policy simply requires a belief that central bank will "do nothing" in future. It won't decrease the money supply back down again.
Roosevelt was at the ZLB. He didn't promise to keep interest rates too low for too long. Roosevelt simply raised the price of gold. And it worked. Because people naturally assumed he would "do nothing" in future. By "doing nothing" they understood "not lowering the price of gold back down again". It worked because people thought of "monetary policy" as "setting the price of gold".
New Keynesian macroeconomists will be tempted to insist that monetary policy really is, is, IS, IS setting interest rates. Any monetarist could insist right back that monetary policy really is, is, IS, IS setting the money supply. And a gold bug could in turn insist that monetary policy really is, is, IS, IS setting the price of gold. That argument will get us nowhere. Nor will arguing over whether fiscal policy really is setting the level of government spending or setting the change in government spending.
It's all in the framing. There is no reality in these matters. These are all social constructions of reality. We theorists shouldn't be suckered into believing that our conceptual schemes are out there in the real world. Except, the conceptual schemes of real people out there in the real world are part of the reality of that world, for a social scientist. And the Neo-Wicksellian social construction of reality, in which "monetary policy" is defined as "setting interest rates", is a damned bad reality to construct. Especially when we hit the ZLB.
Worthwhile Canadian Initiative 
K: that is not how I understood him. I think that what he means could be expressed (very crudely) like this: old way of focusing monetary policy on current inflation (core or not) is worse than claiming that we will keep interest rates too low for too long that is in turn inferior to level path inflation targeting that is inferior to NGDP level path targeting. And the liquidity trap exists only for the first (or maybe even second) case, and the reason is expectations. In my eyes, CB is behaving like a madman. They basically say – Ok, we are going to expand the money supply today, but dare you use it in actual economy so that we close the output gap too fast (inflation above 2%), we will make you suffer for that. That is what he was saying. QE was effective, it increased the inflation expectations, but its effect ended where it clashed with FED policy of 2% ceiling.
FED has too much credibility for inflation stabilization, that in our situation means that it has no credibility for returning NGDP on the pre-recession path quick enough. It was actually FED that brought this recession on us. By not loosening monetary policy in June 2008 FED basically forced a fall in nominal GDP by 10% (from 5% growth from year before to 5% drop). Central bankers would love to pass the responsibility to Obama’s insufficient stimulus using liquidity trap as an excuse. But the bitter truth is, that they actually had the tools to both – spot and prevent this slump. They even had a chairman that understood this and that made his fame on analyzing exactly such tools, but he lacked the courage to implement it. I am strongly convinced that if somebody updates “The Monetary History of the United States, 1961 – 20??” that will be the explanation of why millions had to suffer for so long. How long it will be yet remains to be seen.
(I thought I posted another comment, but it doesn’t seem to be here.)
“Everyone knows Nick is right of center.”
I didn’t know this. How are people defining “center” around here? lol
Nick: Excellent post, as usual. I’ve forwarded it to JB.
Andy: I just checked the spam filter, but can’t find it. Did you fill in the anti-spam letter thingy before posting your comment? Sometimes I forget. Sorry we missed seeing your comment.
David: thanks!
DR: there’s the effect of G on AD, and the effect of G on AS. A permanent increase in G may cause AS to increase, that’s what I was talking about there. But as I said in the post, that isn’t the effect the NKs are looking for at the ZLB. An increase in AS would only make matters worse, at the ZLB, because it causes inflation to fall, and real interest rates to rise.
Nick (or anyone else): I have a question for you that has been bugging me lately. If we assume that increase in price level is caused by aggregate demand being greater then an aggregate supply, how can it be that we have insufficient aggregate demand if we actually have a positive inflation? I am aware of the argument with downward nominal wage rigidity and that small increases in inflation can happen even with deficient AD. But is this really all there is? Is there any research on this that can show how large is this effect, meaning how high should the inflation be to cope with this?
On a side note, just to make sure I am getting some of the ‘cynical’ game theoretic implications right:
Suppose (for argument’s sake) that the independent central bank primarily represents a certain segment of population (group 1) that is extremely worried about the distributional impact of inflation (especially since capital gains are taxed in nominal terms). Such a central bank would prefer to use an upper-limit inflation target rather than a nominal GDP target (anything more explicit would threaten the very institution). Rather than stabilize AD, such a central bank would stabilize inflation (or prices).
Suppose the fiscal authority knows that the central bank works in such a way. The fiscal authority could threaten to use expansionary fiscal policy in a recession (part of which is justified anyway due to micro reasons such as insurance and opportunity costs). Fiscal policy also has a strong distributional impact. If the distributional consequences of fiscal policy make group 1 worse off than if the central bank allowed inflation, perhaps the central bank would preempt the fiscal authority and allow some inflation for macro-adjustment. The fiscal authority would never have to engage in any actual macro-adjustment, except perhaps for micro reasons or to establish credibility with the central bank.
And of course that brings us one level down – if people actually expect inflation there may be no need for any actual expnasion by monetary authorities unless perhaps to build credibility.
… and the supply response is somehow greater than the demand response even though hours increase? I don’t understand. You are saying that in response to the increase in G (adding to AD), consumption falls by the same amount, but then rises as hours increase. So long as the overall effect is an increase in hours worked, then this implies a positive multiplier.
JV: that question has been bugging me (and other macroeconomists) for decades. It’s usually called “inflation inertia”. It’s not just the price level that is sticky and doesn’t want to change; it’s the rate of inflation that is sticky and doesn’t want to change.
Possible explanations:
1. Expectations of inflation very slow to adjust. Firms keep on raising prices, even in the face of excess supply, because they expect other firms to keep on raising prices, so think they still need to raise their prices a bit, just less than other firms are raising theirs. Greg Mankiw has a recent variant on this, where firms are just very slow to update their information on prices (“sticky information”, IIRC).
2. Overlapping price setting plus real rigidity. This is a bit hard to explain clearly in a short comment. Firms change their prices every n periods, with 1/n of the firms changing each period. (This Taylor assumption is a bit different from the Calvo assumption assumed for mathematical tractability in most NK models, because Calvo assumes it’s random). Add in some real rigidity (firms don’t want to change their relative prices much) and you can generate some inflation inertia.
But, I am still surprised at how little inflation has slowed in several countries recently. Maybe there’s a bit of absolute downward nominal rigidity in there too.
It would take me a full post and a lot more thought to give you a clear and satisfactory reply.
I did a post on “Calvo vs Taylor” price setting once, but can’t find it.
DR: There is NO AD response (to a permanent increase in G) in an NK model. The (horizontal) IS curve doesn’t shift. There is only an AS response. If you forced people to work 2 hours a day building useless pyramids, and counted those pyramids as part of GDP, then GDP would (probably) increase even in a classical model (where Y is supply-determined). People will work more hours per day, though (probably) less than 2 more hours per day.
primed: Dunno. What you say doesn’t sound wildly wrong to me. But games between fiscal and monetary authorities can have loads of different equilibria, depending on who moves last, and who can pre-commit.
DR: I should have asked you this much earlier: what is your prior knowledge of OK and NK macro (so I know where you are coming from)?
My peeve in his post was this line, “If the argument assumes that, despite the zero bound, monetary policy can do all that is required, then this should be said so explicitly, because it is somewhat counterfactual.”
Lets forget about the weasel word: “somewhat”. What I see is that the market moves in response to signals from the Fed about what will happen later. What I see is that the market moves in response to QE announcements (both directions). What I see is that the Fed is hitting its inflation target.
It seems really obnoxious of him to be so self-confident about the ZLB issue so as to be pissed when people don’t kiss his feet about it before proceeding.
It would be tempting to go so far as to say that any argument dependent on the ZLB being reached or a liquidity-trap is the counterfactual. We’ve never seen such a point reached (at least not in the expectations driven world in which we live).
Nick: Thanks for explanation and tips for further study. I would love to see some blog on this topic from you in the future. Anyways if there really is general rate-of-inflation inertia not only the one based on nominal rigidities, then it seems to be yet another point for NGDP targeting. If people and firm really can get used to any level of inflation and stick to it, then meeting this fixed inflation expectations by CB will not help solve nominal shocks on economy. A discretionary and not completely predictable monetary policy (in terms of inflation being allowed in a larger interval), can be a boon as it will still retain its power to systematically nudge the economy into a good equilibrium.
I know what I am going to say is completely out of left field but for some reason I have convinced myself in the past few hours that given what is happening with the Swiss National Bank and the BoJ that Bank of Canada intervention in the exchange rate is far more likely to happen than anyone thinks. It would be a black swan event but is there anything in Carney’s or Flaherty’s background to assume that they would oppose it under all circumstances.
I came to this conclusion after having a discussion with someone in the US over who would intervene in EUR/CHR rate on behalf of the SNB during North American trading hours. They thought that politically the Fed would not want to touch the issue to which I responded why wouldn’t the SNB call on the friendly folks at the Bank of Canada in Ottawa to help them out. As I saw I can’t see any politcal and ideological reason why Flaherty or Carney wouldn’t help the Swiss which got me thinking further as to how truely committed are they to Canada’s current non intervention policy.
Tim: that does sound a little out on left field to me ;-).
Why would the Bank of Canada need to do this? I can only see the Bank of Canada intervening in forex markets in two circumstances: some sort of lack of liquidity/market disruption/extreme volatility in forex markets; if it felt that it were totally unable to loosen (or tighten?) monetary policy by other means.