The Difference Between Monetary Policy, Fiscal Policy, and Capital Markets Policy

Paul Krugman is three doors down the hall right now, but I am going to talk to him through the magic of the internet rather than mosying down:

Does unconventional monetary policy solve the zero bound problem?: Some comments on my post on the true cost of fiscal stimulus argue that the zero lower bound aka liquidity trap isn’t really binding, because the Fed is using other measures to expand the economy. A few commenters imply that I haven’t been paying attention.

Well, yes I’m aware that BB is doing a bunch of unconventional stuff. But the available — albeit thin — evidence is that it takes a huge expansion of the Fed’s balance sheet to accomplish as much as would be achieved by a quite modest cut in the Fed funds rate. And the Fed isn’t willing to expand its balance sheet to the $10 trillion or so it would take to be as expansionary as it “should” be given, say, a Taylor rule.

Which means that the zero bound is still binding, which means that right now we’re very much still in liquidity trap territory.

I would put it somewhat differently. There's fiscal policy--using the government to expand output holding the risky long-term real interest rate that governs business investment and household borrowing decisions constant. There's monetary policy---using open-market operations to boost or retard the economy holding the short-term safe nominal interest rate constant. And then there is capital markets policy: operating on the wedge between the risky long-term real interest rate and the short-term safe nominal interest rate.

If you set up those three boxes, then a huge number of things fall under the rubric of "capital markets policy"--banking recapitalization. loan guarantees, nationalizations, bank rescues, asset purchases, and the sending of signals that alter the expected rate of future inflation.

You can call Federal Reserve policies aimed at the sending of signals that alter the expected rate of future inflation "monetary policy" if you want, but then you lose analytical clarity--because the way such policies work (if they work) is not the "normal" way that "normal" monetary policy works. Normal monetary policy works by shifting the private sector's asset holdings toward assets that people spend more readily and rapidly, thus boosting spending. Quantitative easing at the zero bound does not do that: it simply exchanges one zero-yield government asset for another. What is does do is to change bond prices, rather by raising the safe short-term nominal interest rate and thus giving people an incentive to spend the money they already have more quickly.

Comments

[socrateazz:]

I do not know why but your statements confused me. The government has been working on incentives to purchase for years. Once implemented any policy using such a method has deminishing returns. For instance reducing interest rate slightly once caused big changes in spending. As that method was used a greater percentage change in interest was needed to get an expected result. Many people already have spent the limit based on their earnings. Others will not respond to that type manipulation. That method has pretty much played out. There are millions of strategies which could cause more or less purchasing in the future. Most of those strategies will have an opposite effect of reducing production. At any rate any strategy which does not increase the buying power of the people and the production power of the producers will contribute to a worsening economy. Has Obama's policies improved the average persons buying power? Have they led to businesses increasing production? Where do we go from here? I think the cuban model is very possible. But I am just a fool anyway! The fool is the person the majority does not want to listen to until reality causes re-evaluation of beliefs

Oct 01 08:39 AM