Mankiw and Weinzierl: An Exploration of Optimal Stabilization Policy

I haven't had a chance to ready beyond the introduction and conclusion of this paper by Greg Mankiw and Matthew Weinzierl, "An Exploration of Optimal Stabilization Policy," but a couple of quick reactions. First, in the paper, in order for there to be a case for fiscal policy at all, the economy must be at the zero bound and the monetary authority must be "unable to commit itself to expansionary future policy." This point about commitment has been made in other papers (I believe Eggertsson, for example, notes this), and I think the credibility of future promises to create inflation is a problem. If so, if the Fed cannot credibly commit to future inflationary policy, then this paper provides a basis for, not against, fiscal policy when the economy is stuck at the zero bound.

Second, they note in the paper that tax policy can do a better job of replicating the flexible price equilibrium in terms of the allocation of resources, and hence tax policy should be used instead of government spending. However, since I think that there is a strong case that we are short on infrastructure, and that public goods problems prevent the private sector from providing optimal quantities of these goods on its own, I don't see the distributional issues as an important objection to government spending at present.

Here's the introduction to the paper:

An Exploration of Optimal Stabilization Policy, by N. Gregory Mankiw and Matthew Weinzierl March 8, 2011:  1 Introduction What is the optimal response of monetary and fiscal policy to an economy-wide decline in wealth and aggregate demand? This question has been at the forefront of many economists' minds over the past several years. In the aftermath of the 2008-2009 housing bust, financial crisis, and stock market decline, people were feeling poorer than they did a few years earlier and, as a result, were less eager to spend. The decline in the aggregate demand for goods and services led to the most severe recession in a generation or more.

The textbook answer to such a situation is for policymakers to use the tools of monetary and fiscal policy to prop up aggregate demand. And, indeed, during this recent episode, the Federal Reserve reduced the federal funds rate -- its primary policy instrument -- almost all the way to zero. With monetary policy having used up its ammunition of interest rate cuts, economists and policymakers increasingly looked elsewhere for a solution. In particular, they focused on fiscal policy and unconventional instruments of monetary policy.

To traditional Keynesians, the solution is startlingly simple: The government should increase its spending to make up for the shortfall in private spending. Indeed, this was a main motivation for the $800 billion stimulus package proposed by President Obama and passed by Congress in early 2009. The logic behind this policy should be familiar to anyone who has taken a macroeconomics principles course anytime over the past half century.

Yet many Americans (including quite a few congressional Republicans) are skeptical that increased government spending is the right policy response. They are motivated by some basic economic and political questions: If we as individual citizens are feeling poorer and cutting back on our spending, why should our elected representatives in effect reverse these private decisions by increasing spending and going into debt on our behalf? If the goal of government is to express the collective will of the citizenry, shouldn't it follow the lead of those it represents by tightening its own belt?

Traditional Keynesians have a standard answer to this line of thinking. According to the paradox of thrift, increased saving may be individually rational but collectively irrational. As individuals try to save more, they depress aggregate demand and thus national income. In the end, saving might not increase at all. Increased thrift might lead only to depressed economic activity, a malady that can be remedied by an increase in government purchases of goods and services.

The goal of this paper is to address this set of issues in light of modern macroeconomic theory. Unlike traditional Keynesian analysis of fiscal policy, modern macro theory begins with the preferences and constraints facing households and …firms and builds from there. This feature of modern theory is not a mere fetish for microeconomic foundations. Instead, it allows policy prescriptions to be founded on the basic principles of welfare economics. This feature seems particularly important for the case at hand, because the Keynesian recommendation is to have the government undo the actions that private citizens are taking on their own behalf. Figuring out whether such a policy can improve the well-being of those citizens is the key issue, a task that seems impossible to address without some reliable measure of welfare.

The model we develop to address this question fits solidly in the new Keynesian tradition. That is, the starting point for the analysis is an intertemporal general equilibrium model with prices that are assumed to be sticky in the short run. This temporary price rigidity prevents the economy from reaching an optimal allocation of resources, and it gives a possible role for monetary and fiscal policy to help the economy reach a better allocation through their influence on aggregate demand. The model yields several significant conclusions about the best responses of policymakers under various economic conditions and constraints on the set of policy tools at their disposal.

To be sure, by the nature of this kind of exercise, the validity of any conclusion depends on whether the model captures the essence of the problem being examined. Because all models are simplifications, one can always question whether a conclusion is robust to generalization. Our strategy is to begin with a simple model that illustrates our approach and yields some stark results. We then generalize this baseline model along several dimensions both to check robustness and to examine a broader range of policy issues.

Our baseline model is a two-period general equilibrium model with sticky prices in the …first period. The available policy tools are monetary policy and government purchases of goods and services. Like private consumption goods, government purchases yield utility to households. Private and public consumption are not, however, perfect substitutes. (If they were, public consumption would be an irrelevant instrument.) Our goal is to examine the optimal use of the tools of monetary and fiscal policy when the economy …finds itself producing below potential because of insufficient aggregate demand.

We begin with the benchmark case in which the economy does not face the zero lower bound for nominal interest rates. In this case, the only stabilization tool that is necessary is conventional monetary policy. Once monetary policy is set to maintain full employment, fiscal policy should be determined based on classical principles. In particular, government purchases should be set to equate their marginal benefit with the marginal benefit of private consumption. As a result, government purchases are procyclical: When private citizens are cutting back on their private consumption spending, the government should cut back on public consumption as well.

We then examine the complications that arise because nominal interest rates cannot be set below zero. We show that even this constraint on monetary policy does not by itself give a role for traditional fiscal policy as a stabilization tool. Instead, the optimal policy is for the central bank to commit to future monetary policy actions in order to increase current aggregate demand. Fiscal policy continues to be set on classical principles.

A role for countercyclical fiscal policy might potentially arise if the central bank both hits the zero lower bound on the current short-term interest rate and is unable to commit itself to expansionary future policy. In this case, monetary policy cannot maintain full-employment of productive resources on its own. Absent any fiscal policy, the economy would …find itself in a non-classical short-run equilibrium. Optimal fiscal policy then looks decidedly Keynesian. If the only instrument of fiscal policy is the level of government purchases, optimal policy is to increase those purchases to increase the demand for idle productive resources, even if the marginal value of the public goods being purchased is low.

This very Keynesian result, however, is overturned once the set of fiscal tools available to policymakers is expanded. Optimal fiscal policy in this situation is the one that tries to replicate the allocation of resources that would be achieved if prices were flexible. An increase in government purchases cannot accomplish that goal: While it can yield the same level of national income, it cannot achieve the same composition of it. We discuss how tax instruments might be used to induce a better allocation of resources. The model suggests that tax policy should aim at increasing the level of investment spending. Something like an investment tax credit comes to mind. In essence, optimal fiscal policy in this situation tries to produce incentives similar to what would be achieved if the central bank were somehow able to reduce interest rates below zero.

A final implication of the baseline model is that the traditional fiscal policy multiplier may well be a poor tool for evaluating the welfare implications of alternative fiscal policies. It is common in policy circles to judge alternative stabilization ideas using "bang-for-the-buck" calculations. That is, fiscal options are judged according to how many dollars of extra GDP are achieved for each dollar of extra deficit spending. But such calculations ignore the composition of GDP and, therefore, are only loosely tied to measures of welfare.

After developing these results in our baseline model, we examine three variations on it. First, we show how adding a third period allows for the central bank to use long-term interest rates as an additional tool to achieve the flexible-price equilibrium. This policy resembles the current strategy of the U.S. Federal Reserve, 3 sometimes called quantitative easing. Second, we add government investment spending to the baseline model. We show that all government expenditure follows classical principles when monetary policy is sufficient to stabilize output. Even when monetary policy is limited, targeted investment incentives are more effective at reaching a desired allocation of resources than is government investment. Third, we modify the baseline model to include non-Ricardian, rule-of-thumb households who consume a constant fraction of income. The presence of such households means that the timing of taxes may affect output, and we characterize the optimal policy mix in that setting.