“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.