Reassessing Discretionary Fiscal Policy John B. Taylor Stanford University Presented at Amherst College April 25, 2000

Fiscal Policy Gun Is Reloaded Last attempts at discretionary fiscal policy –1992 Bush Stimulus package: rejected –1993 Clinton Stimulus package: rejected Reason for rejection: budget deficit Now deficits are gone, so counter-cyclical policy is ready to be used again But should we use it?

Why a reassessment? Changes in monetary policy –More emphasis on inflation control and keeping aggregate demand close to aggregate supply –More reactive to both inflation and real GDP –Favorable effects on both Changes in macroeconomic policy evaluation research –New normative macroeconomics Example. Monetary Policy Rules, U. Chicago Press, 1999

A Simple Framework For Analyzing Countercyclical Policy y =  ar + u r = b  + v  =  -1 + cy -1 + w r = real interest rate y = real GDP (measured relative to potential GDP)  = the inflation rate u,v, and w are shift terms

Three cases relating to countercyclical monetary policy: (1) Goldilocks economy--ideal, no change (2) Too cold--cut interest rates (3) Too hot--raise interest rates

“Too hot” example from Fed’s Monetary Policy Report, Feb “aggregate demand may well continue to outpace gains in potential output over the near term, an imbalance that contains the seeds of rising inflationary and financial pressures that could undermine the expansion.... [T]he level of interest rates needed to align demand with potential supply may have increased substantially”

Compare discretionary fiscal policy Cyclical goals same as monetary policy: – keep AD = potential when inflation is on target Also shifts AD curve, but –Lags longer (implementation) –Harder to reverse –Could make Fed’s job harder And Fed reacting more than before

Zero Bound on Interest Rate Example of Japan Causes non-linearity in policy rule r = b  (with b > 0) for i > 0 r = i -  = -  for i < 0 –Possibility of downward spiral Kinked aggregate demand curve Role for fiscal policy enhanced

Policy Rule Constant Real Interest Rate Nominal interest rate Inflation rate 0 Target

Figure 2. The Kinked Aggregate Demand Curve. The upward sloping unstable region starts when the zero lower bound on the interest rate is reached. Real GDP

Other arguments Monetary policy constrained by fixed exchange rates Credibility problems prevent central bank from reacting to y

Fiscal and monetary rule together r = h  + gy + r * s = fy + s * where s is the budget surplus as a share of GDP s * is the structural surplus s - s* is the cyclical surplus.

Conclusion Fiscal policy should focus on the automatic stabilizers –Could even become less responsive, as appears to have happened already Save discretionary actions for longer-term issues and for unusual situations when monetary policy might have relatively little power. Monetary policy has done a good job at keeping aggregate demand close to potential GDP. –Seems hard to improve on this performance with a more active discretionary fiscal policy, and such a policy might even make this job more difficult.

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