Isn’t or Shouldn’t?
Friday, June 4th, 2010Sumner argues that if Krugman’s claim is true that the Fed is too conservative, that they will do whatever to curb inflation, then fiscal policy won’t work either. Fiscal policy moves the AD curve right, but the Fed will just move it back left.
Sumners argument only works if policy is not limited by the zero lower bound. Suppose the Fed’s conservative policy requires it to set interest rates at -2%. It can only set them to 0%. When fiscal policy moves the AD curve right, the Fed resets the target rate to -1%, say. Actual rates stay at 0%, the Fed can’t move the AD curve left and so fiscal policy is effective. Sumner says either “the Fed isn’t constrained to just set interest rates (e.g. currency interventions)” or “the Fed shouldn’t be constrained to just set interest rates”.
Its the “isn’t” and “shouldn’t” that is the core of the disagreement. Is there evidence for a political economy constraint on the Fed that prevents it from doing the right thing? As Tyler Cowen put it, assuming AD is too low, why isn’t the Fed following Sumner’s advice? If they’re not following Sumner’s advice then fiscal policy can be effective, right?
