Stimulus Counterfactual

Imagine that there was no hope of a fiscal “stimulus” package ever passing, and instead, the entire responsibility of stabilizing the macro-economy rested on the shoulders of the central bank alone. What would be the outcome? Luckily, Europe is giving us a glimpse:

Short-term rates for borrowing in euros in the forwards market are the cheapest relative to loans in dollars since September. The 50 percent collapse in that spread this month signals investors are betting the European Central Bank will keep its target interest rate at a record low, sacrificing euro strength to prevent deficit cutting by debt-laden economies in the region from stymieing growth.

Fiscal tightening causes expectations of the future path of monetary policy to predict loose money and, in turn, loosens the stance of monetary policy.

Of course, if the monetary authority was targeting the forecast (even its own forecast!) the fiscal multiplier would be exactly zero, as any movement in the future path of NGDP would cause monetary policy to react mechanically to keep NGDP growing on target.

What does this tell us? That the Federal Reserve needs to be stripped of it’s “dual mandate”, and governed by a contract that states that it must set an explicit target (with level targeting), and do everything in its power to hit that target. Then we can forget about the fiscal “stimulus” debate, and life will be easier for everyone.

H/T Scott Sumner


3 thoughts on “Stimulus Counterfactual

  1. I just started to get into a practice account with Forex on currency trading. Since it was practice I just bought little bits of each currency to tr to see patterns. Do you know any sites or blogs that go over currencies frequently?

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