Wednesday, March 30, 2011

Mankiw/Weinzierl: An Exploration of Optimal Stabilization Policy (amv)

Very interesting working paper (my emphasis):
What is the optimal response of monetary and  fiscal policy to an economy-wide decline in wealth and aggregate demand? This question has been at the forefront of many economists’minds over the past several years. In the aftermath of the 2008-2009 housing bust, financial crisis, and stock market decline, people were feeling poorer than they did a few years earlier and, as a result, were less eager to spend. The decline in the aggregate demand for goods and services led to the most severe recession in a generation or more.

The textbook answer to such a situation is for policymakers to use the tools of monetary and fiscal policy to prop up aggregate demand. And, indeed, during this recent episode, the Federal Reserve reduced the federal funds rate - its primary policy instrument - almost all the way to zero. With monetary policy having used up its ammunition of interest rate cuts, economists and policymakers increasingly looked elsewhere for a solution. In particular, they focused on fiscal policy and unconventional instruments of monetary policy.

To traditional Keynesians, the solution is startlingly simple: The government should increase its spending to make up for the shortfall in private spending. Indeed, this was a main motivation for the $800 billion stimulus package proposed by President Obama and passed by Congress in early 2009. The logic behind this policy should be familiar to anyone who has taken a macroeconomics principles course anytime over the past half century.

Yet many Americans (including quite a few congressional Republicans) are skeptical that increased govenrnment spending is the right policy response. They are motivated by some basic economic and political questions: If we as individual citizens are feeling poorer and cutting back on our spending, why should our elected representatives in effect reverse these private decisions by increasing spending and going into debt on our behalf? If the goal of government is to express the collective will of the citizenry, shouldn't it follow the lead of those it represents by tightening its own belt?

Traditional Keynesians have a standard answer to this line of thinking. According to the paradox of thrift, increased saving may be individually rational but collectively irrational. As individuals try to save more, they depress aggregate demand and thus national income. In the end, saving might not increase at all. Increased thrift might lead only to depressed economic activity, a malady that can be remedied by an increase in government purchases of goods and services.

The goal of this paper is to address this set of issues in light of modern macroeconomic theory. Unlike traditional Keynesian analysis of fiscal policy, modern macro theory begins with the preferences and constraints facing households and firms and builds from there. This feature of modern theory is not a mere fetish for microeconomic foundations. Instead, it allows policy prescriptions to be founded on the basic principles of welfare economics. This feature seems particularly important for the case at hand, because the Keynesian recommendation is to have the government undo the actions that private citizens are taking on their own behalf. Figuring out whether such a policy can improve the well-being of those citizens is the key issue, a task that seems impossible to address without some reliable measure of welfare.

[...] We begin with the benchmark case in which the economy does not face the zero lower bound for nominal interest rates. In this case, the only stabilization tool that is necessary is conventional monetary policy. Once monetary policy is set to maintain full employment, fiscal policy should be determined based on classical principles. In particular, government purchases should be set to equate their marginal bene…t with the marginal benefit of private consumption. As a result, government purchases are procyclical: When private citizens are cutting back on their private consumption spending, the government should cut back on public consumption as well.

We then examine the complications that arise because nominal interest rates cannot be set below zero. We show that even this constraint on monetary policy does not by itself give a role for traditional fiscal policy as a stabilization tool. Instead, the optimal policy is for the central bank to commit to future monetary policy actions in order to increase current aggregate demand. Fiscal policy continues to be set on classical principles.

A role for countercyclical fiscal policy might potentially arise if the central bank both hits the zero lower bound on the current short-term interest rate and is unable to commit itself to expansionary future policy. In this case, monetary policy cannot maintain full-employment of productive resources on its own. Absent any fiscal policy, the economy would find itself in a non-classical short-run equilibrium. Optimal fiscal policy then looks decidedly Keynesian. If the only instrument of fiscal policy is the level of government purchases, optimal policy is to increase those purchases to increase the demand for idle productive resources, even if the marginal value of the public goods being purchased is low.

This very Keynesian result, however, is overturned once the set of fiscal tools available to policymakers is expanded. Optimal fiscal policy in this situation is the one that tries to replicate the allocation of resources that would be achieved if prices were flexible. An increase in government purchases cannot accomplish that goal: While it can yield the same level of national income, it cannot achieve the same composition of it. We discuss how tax instruments might be used to induce a better allocation of resources. The model suggests that tax policy should aim at increasing the level of investment spending. Something like an investment tax credit comes to mind. In essence, optimal fiscal policy in this situation tries to produce incentives similar to what would be achieved if the central bank were somehow able to reduce interest rates below zero.
UPDATE (10.04): I just found out about an earlier post by Kantoos Economics introducing the same paper. The arguments about Keynesianism and Friedman are debatable, the relevant demarcations quite imprecise.