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Thursday, July 09, 2015

'Fiscal Policy and the Long-Run Neutral Real Interest Rate'

Narayana Kocherlakota, President of the Federal Reserve Bank of Minneapolis, says more government debt would help the Fed:

Fiscal Policy and the Long-Run Neutral Real Interest Rate: Thanks for the introduction and the invitation to be here today.
In my remarks today, I will make three points about the U.S. economy.
First, there has been a significant decline in the long-run real interest rate, reflecting (in large part) a decline in what is sometimes called the long-run neutral real interest rate. (By the long-run neutral real interest rate, I mean the real interest rate that I expect to prevail when the economy is at maximum employment and inflation is at the central bank’s target.) Second, this decline in the long-run neutral real interest rate is likely to mean that monetary policymakers will be more constrained by the lower bound on the nominal interest rate in the future than they have been in the past. 
My third point concerns an important connection between monetary and fiscal policy. I consider a permanent increase in the market value of the public debt, financed by an increase in taxes or reduction in transfers. This policy change increases the supply of assets available to investors. I argue that, in a wide class of plausible economic models, such an increase in supply would push downward on debt prices, and so upward on the long-run neutral real interest rate. 
When I put these three points together, I reach my main conclusion. The decline in the long-run neutral real interest rate increases the likelihood that the economy will run into the lower bound on nominal interest rates. Accordingly, there is an enhanced risk that the Federal Open Market Committee (FOMC) will undershoot its maximum employment and 2 percent inflation objectives. Fiscal policymakers can mitigate this risk by choosing to maintain higher levels of public debt than markets currently anticipate.
I want to be clear at the outset that I am not saying that it is appropriate for fiscal policymakers to increase the long-run level of public debt. I am simply pointing to one benefit associated with such an increase: It allows the central bank to be more effective in mitigating the impact of adverse shocks to aggregate demand. I will point to other costs (and benefits) associated with increasing the level of public debt. Sorting through them is outside the scope of my remarks today, and really outside of my purview as a monetary policymaker. ...

    Posted by on Thursday, July 9, 2015 at 08:59 AM in Economics, Fiscal Policy, Monetary Policy | Permalink  Comments (63)


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