Will a fiscal stimulus in the US not be inflationary?

According to Martin Feldstein (hat tip Greg Mankiw):

“Even if the Fed decides that it should not cut rates further at the present time, it would not raise rates to offset the stimulus effect of the fiscal change. From the Fed’s point of view, the tax cuts can provide a desirable short-run stimulus without the inflationary impact that would result from a lower interest rate and an increase in the stock of money.”

Just because Martin Feldstein is a far, far, better economist then I will ever be does not mean that I have to agree with him, and here’s why.

In the above passage, Martin seems to believe that a fiscal stimulus does not effect the money market. However, on this point I believe he is wrong.

If the government cuts taxes it will increase money demand. Now the Fed has a cash rate target, but also controls the supply of money. If money demand rises the Fed can either keep the supply of money fixed (which would involve increasing the interest rate) or keep to its cash rate target (which would involve increasing the supply of money), or a mix of both. The Fed cannot magically determine the quantity and price of money, it is constrained by the money demand curve.

As a result, both fiscal policy and a lower interest rate are inflationary. Fiscal policy shifts the demand for money right, which implies that a greater quantity must exist for the given interest rate, while lowering interest rate (price) involves moving down the current money demand curve, which in turn increases the quantity of money.

  • Owen

    “If the government cuts taxes it will increase money demand. ”

    Flesh this statement out for me if you will please.

  • Sure, money demand is a positive function of nominal income (the higher your nominal income is, the more nominal money you require to purchase things). A cut in taxes by itself will increase peoples nominal income, shifting money demand right.

  • Owen

    But you just get to keep more of the money you already have, nominal income is not changed.

  • Ahh sorry I should say nominal disposable income, that was just sloppy of me.

    Higher disposable income increases demand for goods, which in turn increases demand for nominal money. Either the price of money can rise (the nominal interest rate), the quantity of money can rise, or a bit of both. What happens is up to the Federal Reserve.

  • Owen

    Even so, unless people get paid in anything other than money, that money is already in the system, just that some goes off to the govt to spend. With tax cuts, less of that money is diverted to the govt, its still the same amount of money being spent.

  • No, the government has a claim on the money they spend, as we have a fiscal injection government spending must fall by less than the tax cuts.

    The cut in taxes then increases the claim on money that households have. As a result either the price of money must rise or the quantity of nominal money must increase or a bit of both.

    If the government cut spending by the same amount as the tax cut, then we would have no inflationary pressure, however this would not be a fiscal injection as the injection into the economy is meet by an equal withdrawal.

  • Owen

    I guess in a round about way (and being slightly pedantic), thats what I was getting at/not understanding. Its not the tax cut, but rather the govt printing more money to offset increased spending, that is inflationary.

  • Yes, but the tax cut is the reason that the Fed may need to print more money, as the demand for money is greater. The government themselves are not printing money, it is the Fed’s call on whether to increase the price of money or increase the quantity of money in the face of higher money demand. The tax cut is inflationary as it is the mechanism that leads to an increase in the quantity of money.

    Remember one way of viewing inflation is by the rate of growth in the money supply (taking into account increases in output of course). Saying that more money being printed is inflationary is a tautology, we are interested in looking at the factors that lead to a higher quantity of nominal money being required in equilibrium. In this sense, tax cuts are inflationary, as they are the mechanism that leads to an increase in demand for money, which in turn leads to a higher quantity of nominal money in equilibrium (unless money supply is fixed, in which case the nominal interest rate MUST rise).

    The point is that Martin said we could have expansionary fiscal policy without changing the nominal interest rate or the quantity of money. This is not possible, as the Fed has to choose a point that is on the money demand curve.

  • Owen

    I just actually went and read the article, I dont think thats what he was saying at all.

    He is essentially saying that being so close to a recession, and hence very low/no inflation, a tax cut is preferable to lower interest rates to help the economy recover, and because of the current climate, there is no need to offset the fiscal stimulus with higher interest rates.

  • I guess we are just reading what he said differently, which is perfectly reasonable.

    However, I just don’t think that saying “the tax cuts can provide a desirable short-run stimulus without the inflationary impact that would result from a lower interest rate and an increase in the stock of money” is appropriate, ever. A lower interest rate will give the same stimulus as a cut in taxes to the point where the quantity of money is at the same point, the only difference is in the distribution.

    Furthermore, tax cuts aren’t usually used as a stabilising instrument (unlike interest rates) because of Ricardian equivalence and the fact that it is more difficult in administrative terms to introduce and remove tax cuts (as well as the fact that governments aren’t the best at handling economic stabilisation). With credit tight, I don’t think Ricardian equivalence will hold, but that does not stop a tax cut being administratively more difficult than a change in interest rates.

  • Owen

    I think in the context of the conditional and targeted tax cut he is talking bout what he says holds true, but certainly if you apply it much more broadly it does not, as you have pointed out.

  • Ahhh yes, having fiscal policy as an automatic stabiliser. He suggests that the best way to do this would be to have it so there is a fiscal stimulus whenever there are “three-month(‘s of) cumulative decline in payroll employment”.

    Interesting, but I still think that having the Fed change interest rates based on current information would be better than this arbitrary rule which has a three-month delay and does not take account of the wider economic situation. Secondly he does not suggest a targeted tax cut, he suggests “a uniform tax rebate per taxpayer or a percentage reduction in each taxpayer’s liability”. A targeted tax cut would only provide less inflationary pressure if the savings rate of the group it went to was higher, of course it would also provide less of a fiscal stimulus.

    Towards the end he suggests that if they used fiscal and monetary policy nominal interest rates would not need to fall as far. I can buy that line, however as the additional government spending will be inflationary surely the real interest rate would be the same in each case (although this depends on how ‘sticky’ prices are). I actually think there is a possibility for this type of dual mechanism, which could be sorta cool.

    However, in the quote I’m talking about he said that if the Fed did not want to cut rates anymore, they would not lift rates in the face of a large fiscal stimulus as it would not be inflationary. This is nonsense, it would be inflationary, and if the Fed was previously in neutral mode, it would turn hawkish, in order to prevent the quantity of money growing too quickly.

  • There is a dissident point of view, the real bills doctrine, that is worth some attention. Sargent, Cunningham, Siklos, Bomberger, and others have found that easy fiscal policies are inflationary and tight fiscal policies are deflationary, but not for the reasons you discuss. An easy fiscal policy makes people doubt the future solvency of the government, so the government’s bonds lose value. The central bank holds some of those bonds as backing for the dollars it has issued, so when the bonds lose value, the dollar has less backing, so the dollar loses value.