It is time for the world’s major central banks to reconsider how they conduct monetary policy. The US Federal Reserve and the European Central Bank are grappling with sustained economic weakness, despite years of low interest rates. In Japan, Shinzō Abe, the opposition Liberal Democratic Party’s (LDP) candidate for prime minister, campaigned for a more expansionary monetary policy ahead of the general election on December 16. And central banks in the United Kingdom and China are coming under new leadership, which might entail new thinking.
Monetary policymakers in some countries should contemplate a shift toward targeting nominal GDP – a switch that could be phased in gradually in such a way as to preserve credibility with respect to inflation. Indeed, for many advanced economies, in particular, a nominal-GDP target is clearly superior to the status quo.
The answer to the question which form of policy is more effective: under the circumstances that held in the 1930s and that hold again now – which are conditions not just of high unemployment and low inflation, but also near-zero interest rates — stimulus in the specific form of fiscal expansion is much more likely to be effective in the short-term than stimulus in the form of monetary expansion. Monetary expansion is rendered relatively less effective because interest rates can’t be pushed below zero. This situation, labeled by Keynes a liquidity trap, is today called the Zero Lower Bound. In addition, firms are less likely to react to easy money by investing in new plant and equipment if they can’t sell the goods they are producing in the factories they already have. The hoary — but still evocative — metaphor is “pushing on a string.” Meanwhile, fiscal expansion is rendered relatively more effective, in that it doesn’t push up those rock-bottom interest rates and thereby crowd out private-sector demand.
Despite the inability of central banks to push short-term nominal interest rates much lower, one should not give up completely on monetary policy, especially because fiscal policy is so thoroughly hamstrung by politics in most countries. It is worth trying all sorts of things: quantitative easing, forward guidance, nominal targets. But the effects of each are highly uncertain. That monetary policy is less effective than fiscal policy under conditions of high unemployment and zero interest rates should not be a novel position. But many economists have forgotten much of what they knew and politicians may not have even heard the proposition.