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 ratey = real GDP (measured relative to potential GDP) = the inflation rate u,v, and w are shift terms

        

INFLATIONRATE

INFLATIONRATE

IA IAIA

Potential GDP

Potential GDP

Potential GDP

ADADAD

REAL GDP REAL GDPREAL GDP

INFLATION RATE

1

2

3

1

2

3

1

2

3

FIGURE 1. Keeping Aggregate Demand in Line with Potential GDP

 

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. 2000.

• “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 ruler = 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 rate0Target

              Figure 2. The Kinked Aggregate Demand Curve. The upward sloping unstable region starts

when the zero lower bound on the interest rate is reached.

Inflation Rate

AD

IA

0

 

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.

Table 1. Response of the Surplus and Its Components to the Output Gap

Sample period structural cyclical (f) total

1960.1 – 1982.4 -.13 .45 .32

1983.1 – 1999.3 .31 .37 .68

1960.1 – 1999.3 .01 .43 .45

-8

-6

-4

-2

0

2

4

60 65 70 75 80 85 90 95

Actual surplus

Fiscal policy rule:Structural surplus + .5Gap

Percent of GDP

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.

END