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Saturday, August 24, 2013

'Missing the point at the IMF'

Simon Wren-Lewis is frustrated with the IMF (for good reason):

Missing the point at the IMF, by Simon Wren-Lewis: The IMF have just published a working paper entitled: ‘Assessing the Impact and Phasing of Multi-year Fiscal Adjustment: A General Framework’. Or to put it more simply: should austerity be front loaded or delayed? A really important topic and one where the views of the IMF are of some importance.

I guess if you call anything a ‘General Framework’ you are taking a risk. But honestly, if you also write this

“our framework does not explicitly model the monetary policy response, which could have an important impact on output”

then you have no business using the word ‘Framework’, let alone ‘General’. [1]

We need to go through the logic one more time. When monetary policy is not constrained (we are not at the Zero Lower Bound), monetary policy can (and to a first approximation should) completely offset the impact of any fiscal consolidation. The multiplier in that case will be approximately zero. [2] However if we are at the ZLB, then within the current monetary policy framework (essentially inflation targeting), and unless you are really optimistic about unconventional policy, the ability of monetary policy to stimulate aggregate demand is severely compromised. As a result, any fiscal multiplier will be substantially greater than zero.

Now consider two periods. In the first, we are at the ZLB. In the following period, we are not. Consider two fiscal consolidation programs. In the first, everything is front loaded into the first period. In the second, nothing happens in the first period, and all fiscal consolidation takes place in the second. Design the two programs so that we end up with the same debt to GDP ratio by the end of the second period, so they are neutral in this respect.

What is the overall impact on output of the two programs? Frontloading hits output in the ZLB period, with possible hysteresis effects in the second. Delaying consolidation until the second period has no impact on output whatsoever, because any impact on output is offset by monetary policy. Simple. So the choice is a no-brainer - you delay fiscal adjustment until the ZLB period has ended.

You would think that with these very dramatic implications for the optimal path for fiscal consolidation, allowing for monetary policy would have to be part of any ‘general framework’. ...

This is by now such an obvious and basic point I can only wonder why it is not incorporated into the analysis. By ignoring this point, what has been done is just inapplicable to some major economies. I do not like being so critical and blunt, but this is no academic debating point. And I would hate to think that this reasoning has been ignored precisely because its implications about the timing of fiscal consolidation are so clear. ...

    Posted by on Saturday, August 24, 2013 at 09:02 AM in Economics, Fiscal Policy, Monetary Policy | Permalink  Comments (33)



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