1. If the central bank is doing it right, and targeting the right level of Aggregate Demand, there is no case for fiscal policy to try to influence AD. It's not needed. And it won't affect AD anyway, because the central bank will offset any changes to fiscal policy to keep AD on target.
Fiscal policy should stick to its microeconomic knitting. It should build more schools when there's a baby boom and more kids need more schools, and not when there's an AD bust and the economy needs more AD. It should build fewer schools when there's a baby bust and fewer kids need fewer schools, and not when there's an AD boom and the economy needs less AD. Getting the number of schools right is the fiscal authority's job. Getting AD right is the central bank's job. It would be silly to have the fiscal authority try to do two incompatible jobs at once, while the central bank just sits there unemployed watching it fail. Ditto for tax/transfer policy too. Tax/transfer policy matters for microeconomic cross-sectional and intergenerational efficiency and equity. It can and does transfer command over resources between current and future generations; time-travel is possible.
2a. If the central bank is doing it right on average, but making random mistakes in hitting its AD target, there is still no case for fiscal policy. It is not obvious why the fiscal authority should be smarter than the central bank at foecasting AD. And if it is smarter, it could just give the central bank its superior forecasts. Nor is it obvious that the fiscal authority could react to forecasts more quickly than the central bank (though there might be a case for automatic fiscal stabilisers, that can react before anyone even knows that AD is too high or too low).
2b. If the central bank is targeting AD, but targeting the wrong level of AD, there is still no case for fiscal policy. If the central bank is targeting too low a level of AD, the central bank will offset any changes in fiscal policy, to keep AD too low, but just right for the central bank's too low target.
3. So, what is the third-best case for using fiscal policy to control AD?
You can't just say: 'The central bank is failing to hit its AD target, therefore we need fiscal policy to help it hit its target' (not an exact quote, but I think that's what Paul Krugman is saying to David Beckworth) and leave it at that.
If the central bank is consistently failing to hit its announced AD target, then either its true target is different from its announced target, or else that announced AD target is not feasible.
If you were principal, and your agent were consistently failing to hit his announced target, what would you do? Would you immediately pitch in to help out? Wouldn't you worry about the moral hazard problem that might create? If he knows you will help him out when he comes in below target, he has an incentive to slack off even more.
I wouldn't do that. I would hold an agent responsible to hitting his announced target. And if he says it is impossible for him to hit his announced target, and if I believed him, I would tell him to change the announced target to one he can hit.
If a central bank runs out of things to buy (or needs to start buying things I don't want it to buy), and AD is still below the announced target, then I would believe that the announced AD target is not feasible (or not desirable). Then I would tell the central bank to change the announced target to one that is feasible. Paradoxically, this would mean that the announced target AD growth rate should be raised to make it feasible. Because a higher inflation target (or higher NGDP growth rate target) means a smaller central bank (as a ratio to NGDP).
I do not know of a single case where a central bank has run out of things to buy.
Economists worry (rightly) about the moral hazard problem of bailing out commercial banks when they fail to meet their announced targets (which is to maintain convertiblity of their money into central bank money at par).
Economists should also worry about the moral hazard problem of using fiscal policy to bail out central banks when they fail to meet their announced AD targets. One of the reasons we want central banks to announce their targets is so we can hold them accountable for hitting their announced targets.
Back to marking exams.
Worthwhile Canadian Initiative 
Monetary policy is always faster then fiscal policy? Got any real world proof to go with the very, very, very crucial assumption? I mean we are talking an unhedged judgement about the most important policy question in economics. Sure seems like something worth checking if it actually works in the real world like we have, many times, with Keynesian stimulus.
Also, what evidence is there that “moral hazard” exists among central bankers? I mean over in Europe policy makers refused to “bail out” the ECB but the ECB was a disgrace to the profession so it seems like incompetent fiscal and monetary policy go hand in hand. Or is it supposed to be a long term thing? Do we accept three or four repeats of the Great Depression with panache, knowing that our central bankers will be so amazing when we wring the moral hazard out of the system?
John: take 9/11 as an example. IIRC, central banks reacted the next day, if not within hours. How long would it take to decide on and implement a new budget? Even in normal times, the Bank of Canada has a fixed announcement Date 8 times a year, using the latest data from a couple of days before. Budgets don’t get changed that quickly.
In the mid 90’s, there was a massive tightening of Canadian fiscal policy. From big deficits to big surpluses. Did we see a recession or fall in inflation? No. The Bank of Canada kept inflation on target. Because it was held accountable for doing that. So much for observing Keynesian (negative) stimulus working.
” I mean over in Europe policy makers refused to “bail out” the ECB…”
??? They won’t let the ECB do QE, which is what it needs to do. The ECB is bad, but the fiscal policymakers won’t even let it do the little it wants to do. Let alone holding it accountable for doing what it is supposed to be doing.
Nick: reaction speed is an institutionnal set-up, based mostly when government had to rely on thugs stealing bits of metal from peasants and finding it easier if they somehow agree to get back part of it. It’s not basic economic science except in the sense that, being in the real world, we have to take it into account.
Nick,
I fully accept that in a totally free market and given a recession, interest rates would fall. But what’s to stop them falling of their own accord? No much, far as I can see. So why have government amplify the process?
But falling interest rates is NOT ALL that would happen in a perfect market. Another phenomenon is the Pigou effect: that is, the fact that supply for almost everything exceeds demand would mean that prices generally would fall, which means the value of the monetary base (and government debt) rises in real terms. That rise in the value of private sector net financial assets would induce the private sector to increase spending not just on borrowing / investment items, but also on non-borrowing based / non-investment items.
But in the real world, the Pigou effect is stymied by the wages being “sticky downwards” phenomenon. Thus in contrast to interest rates, there IS A CASE for having government amplify the process, and government can do that by increasing its own spending and by increasing household spending (e.g. via tax cuts).
Jacques René Giguère,
I agree with your comment just above. Also, 9/11 was a highly unusual event calling for ultra-fast reaction, and in that case an interest rate cut was doubtless a good idea. In contrast, recessions (and recoveries from recessions) take place much more slowly, which gives time for fiscal adjustments.
Also, the UK adjusted its sales tax (VAT) twice, and at the flick of a switch, during the recent crisis. Thus quick fiscal changes are perfectly feasible given the right institutional set up.
@Ralph:
The logic of this is delightfully obvious; the rough definition of the private sector we have is; people foregoing a safe investment and making a riskier one or consuming.
If the problem at hand is that people are making too few riskier investments and consuming to little (both however measured); there is a sort of ineluctable clarity in suggesting taking the action that most directly increases precisely that action which is missing. Hard to argue against that. And it does seem you are making the less demanding point that your prescription is merely superior.
I like it, I’ll use it. However, by all accounts the government is building bridges at a lower than normal rate. Persuasive analysis has been offered that MANY npv positive ‘bridges’ are not being built. I think its fair to add to your post some comment on that, given that it is a huge direct assumption of your point – and the one that is hanging people up in adopting it. Even if the problem is primarily mixing two different problems together.
It could even be that monetary policy alone can achieve the right level of investing and consumption EVEN when bridge building is not happening or even when, as is the case now apparently, bridges which are npv positive are not built. So fine, you still have the oddity of why aren’t those npv projects being done? It must by definition be a problem or else they wouldn’t be npv positive. What ineluctable action can or should be taken to push those npv projects to happen?
This post ages well.
dan: “However, by all accounts the government is building bridges at a lower than normal rate.”
The Canadian or US government? This is purely anecdotal, but when I drove to Winnipeg this last summer it seemed to me (I probably exaggerate) that every second bridge on the trans-Canada was being repaired/replaced. Presumably by our Conservative federal government. Which pleased me, given the low real interest rates at which it can borrow, though I haven’t seen any NPV calculations, even though I had to do a 600km detour when one new bridge slipped and blocked the road.
Nick,
“I do not know of a single case where a central bank has run out of things to buy.”
Strange since central banking (at least in the U. S.) preceded open market operations by about 10 years. I understand the validity of your point, but the existence of a central bank does not automatically mean it has the authority to buy anything. Also, here is the comprehensive list of central banks:
http://www.centralbanksguide.com/central+banks+list/
There are currently 5 countries without any government debt:
http://www.therichest.com/rich-list/rich-countries/the-only-5-countries-in-the-world-living-debt-free/4/
Macao
British Virgin Islands
Lichtenstein
Brunei
Palau
Of these countries, Macao has its own central bank – http://www.amcm.gov.mo/cIndex.htm
What does the Macao central bank buy?
“The government should already be building as many bridges as have positive net-present-value”
Would that be an NPV calculation based on the additive economic benefits of said bridge (time saved, gas saved,etc), or based strictly on cash flow analysis, the later seems problematic as it does not consider the toll as a tax, and is not offset by a loss of consumption elsewhere.
“government can do that by increasing its own spending and by increasing household spending (e.g. via tax cuts)”
I walk into a wall on that every time because I look at it (holding to the simplified example in the concurrent thread Y=C+G) and feel bound by substituting G = (Y * Tax rate), therefore making C = (Y * (1 – T rate)) and, never avoiding a good circular reference, … Y= C + (Y * T rate)
“It’s relatively easy to test whether QE moves asset prices, because asset prices move quickly in response to news, so we can look at event studies “
I would say the exact opposite. Any well done event study should leave one scratching their heads at the results. Formally, it would be very difficult to do, as you would have to filter it by deviation from expectations, obtain all those expectations, probably resulting in the person doing the study to then ignore all data that did not exceed those expectations, or for which they were unable to obtain expectations, which would therefore leave you no longer modeling all news vs. response but instead extreme deviations in ‘some’ news vs response (which should be more obvious, anyway). Then time becomes an issue, move over/within what time frame? Then, probably most important, is that isolating news at t0 is extremely difficult, as too many other events are occurring simultaneously at t0. There is wisdom in the adage. “Buy the rumor, sell the news”, which is, if you try and chase the news tape, start looking for other work.
I was thinking of the US government at the moment, but also more generally.
it strikes me that it would be useful to know if the NPV projects are being built or not – over time and across countries.
even if Canada is at some optimal point today – has it always been?
how can this not be as interesting as examining employment relative to nairu or output relative to potential with an eye towards monitoring activity in the private sector?
Why shouldn’t the government’s role in building npv projects be measured and aimed for etc just as employment and inflation are?
Dan,
http://en.wikipedia.org/wiki/Net_present_value
“The NPV of an investment is determined by calculating the present value (PV) of the total benefits and costs which is achieved by discounting the future value of each cash flow (see Formula). NPV is a useful tool to determine whether a project or investment will result in a net profit or a loss because of its simplicity. A positive NPV results in profit, while a negative NPV results in a loss.”
Does government operate with a profit / loss statement? Does a lack of profits doom a government to bankruptcy, insolvency, etc.?
Min said: “The question of counterfactuals is why we study history. 🙂 Does the Long Depression of the late 19th century have no lessons for us today? Especially since the US had no central bank at that time. My guess is that it does, but who is talking about it?”
What years are you talking about here?
Gold standard?
Does government operate with a profit / loss statement? Does a lack of profits doom a government to bankruptcy, insolvency, etc.?
Yes, no, no – at least that’s my view assuming you have your own currency.
But the question really is not about the government but the economy. Does an economy have a profit/loss statement? It’s a good question because Germany might say yes, but a closed economy, or the entire global economy is a different story.
I think maybe the way to measure it is does the economy have growth which we can pencil in as Total Factor Productivity growth as the best measure, perhaps.
This is essentially the question that is interesting. You have a huge amount of analysis around the economy built up around balancing risk taking and resources, and you have a relatively important economic agent who isn’t bound by a risk profile in any sense meaningful to that analysis and I can’t find any one focusing on what drives this agent’s economic decisions. Where has anyone advanced an analysis for what size the government should be to optimize economic output?
It strikes me as the most interesting in economics to examine at the moment. Far more interesting than the endless discussions about the best way to use policy to influence risk taking and consumption which has been rather exhaustively argued at least enough to be pushed up against the boundaries of what can be demonstrated through data meaningfully enough to advance the collective understanding.