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Sunday, October 11, 2015

'One Reason Why Monetary Policy is Preferred by New Keynesians'

Simon Wren-Lewis:

One reason why monetary policy is preferred by New Keynesians: ...Suppose, for example, individuals decide for some reason that they want to hold more money. They expect to sell their output, but plan to buy less. If everyone does this, aggregate demand will fall, and producers will not sell all their output. If goods cannot be stored, and if producers cannot consume their own good, this could lead to pure waste: some goods remain unsold and rot away. (If all producers immediately cut their prices, then a new equilibrium is possible where producers’ desire to hold more real money balances is achieved by a fall in prices. So we need to rule this possibility out by having some form of price rigidity.)
The government could prevent waste in two ways. It could persuade consumers to hold less money and buy more goods, which we can call monetary policy. Or it could buy up all the surplus production and produce more public goods, which we could call fiscal policy. Both solutions eliminate waste, but monetary policy is preferable to fiscal policy because the public/private good mix remains optimal.
Three comments on this reason for preferring monetary policy. First, if for some reason monetary policy cannot do this job, clearly using fiscal policy is better than doing nothing. It is better to produce something useful with goods rather than letting them rot. We could extend this further. If for some reason the impact of monetary policy was uncertain, then that could also be a reason to prefer fiscal policy, which in this example is sure to eliminate waste. Second, the cost of using fiscal rather than monetary policy obviously depends on the form of public spending. If the public good was repairing the streets the market was held in one year earlier than originally planned the 'distortion' involved is pretty small. Third, another means of achieving the optimal solution, besides monetary policy, is for the government to give everyone the extra money they desire.

    Posted by on Sunday, October 11, 2015 at 10:23 AM in Economics, Fiscal Policy, Monetary Policy | Permalink  Comments (99)


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