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Monday, May 14, 2012

"The Zero Lower Bound and Output Gap Uncertainty"

I've argued again and again that the costs associated with policy errors are asymmetric, and that we'd be better off making the mistake of doing too much rather than too little. This was based on the claim that the costs of high unemployment are larger than the costs of inflation, but as Simon Wren-Lewis shows, this is not the only way to derive this policy result (i.e. the need for more aggressive fiscal policy can be justified in more than one way):

The Zero Lower Bound and Output Gap Uncertainty, by Simon Wren-Lewis: There is currently a great deal of uncertainty about the size of the output gap in the US, UK and elsewhere. Given the significant lags between fiscal policy decisions and their impact, does that mean we should be especially cautious in setting policy? This might seem like a rather academic question at present, because policymakers are not even trying to use fiscal policy to close the output gap... However, uncertainty about the output gap is often used as a justification for maintaining current policies, so it is a relevant question in that sense.              
I believe that there is a strong argument that goes in exactly the opposite direction. Uncertainty about the output gap should make us less cautious. This argument rests on two very reasonable assumptions: that monetary policy can impact on the economy more rapidly than fiscal policy, and that the Zero Lower Bound (ZLB) for nominal interest rates means that there is an asymmetry in what monetary policy can do. Let me try and illustrate the point with some stylised numbers. ...                        
In turns out we do better under the overshooting policy... If this result seems paradoxical, think of it this way. In [the] scenario ... where the current output gap is higher than we think it is, we can do nothing to correct our error. We suffer the full consequences of our mistake: higher unemployment. However in the opposite case,... where the output gap is lower than we think, we have an insurance policy that can cover our mistake to some extent, because we can raise interest rates to moderate inflation. Because of the ZLB, this insurance policy only operates one way.            
Now of course these numbers are arbitrary, but the principle holds: with a one way insurance policy, its best to go for an overshooting policy to some degree. ... It is best to aim too high, because we have a one-way insurance policy. This is why a government that undertook austerity based on the assumption that, if everything went as expected, things would turn out OK was making an obvious mistake – the ZLB meant it had no option if things turned out worse. So, the next time someone argues that we need austerity because we are uncertain about how large the output gap is, ask them why they are ignoring the option of raising interest rates if core inflation starts to rise.    


    Posted by on Monday, May 14, 2012 at 11:07 AM in Economics, Fiscal Policy | Permalink  Comments (50)


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