Isn’t or Shouldn’t?

Sumner 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?

7 thoughts on “Isn’t or Shouldn’t?”

  1. Sumner often points out that Bernanke doesn’t say that the Fed can’t create higher inflation, but that higher inflation would be bad.

  2. If this is evidence that the Fed is not following Sumner’s advice than given what ever political constraint this results from, the zero lower bound is constraining monetary policy and by Krugman’s argument, fiscal policy can work.

    To argue for an optimal policy ignoring this political constraint, which is Sumner’s “should” argument, is missing the point. Given the constraint exists, his preferred policy is no longer optimal.

    The other possibility, which I don’t think Sumner likes, is that the Fed is following Sumner’s optimal policy but AD is not deficient. In any case, Sumner can’t have it both ways.

  3. just remembering some of the old debates we had…

    That if the Fed did any more QE back in January, we’d be at 10% inflation. Worried about the risk of hyperinflation, of course, the Fed did nothing, and we had -.2% inflation in May and we’ve got a still-depressed economy. On the year we’re looking at a CPI which has increased 0.0%, well below the Fed’s target which is itself too low.

    That most of the stimulus spending would come long after the recession was over. Over half of the stimulus funds have been spent, and we’re still at 9.7% unemployment. And were it not for the Census, we might well be at 10.

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