Why the Economy Is Recovering Slowly

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from NCPA,

Many observers have been per­plexed by the slow recovery from the 2008 recession. In the United States, Congress passed a nearly $800 billion stimulus in early 2009, yet growth remained sluggish, says Scott Sumner, a professor at Bentley University.

Why has the effect of fiscal stimulus been so meager in recent years? The most likely explana­tion is monetary offset, a concept built into modern central bank policy but poorly understood.

– Let’s assume that the central bank is targeting infla­tion at 2 percent.

– If fiscal stimulus works, it’s by shifting the aggregate demand (AD) curve to the right. This tends to raise both prices and output, although in the very long run, only prices are affected.

– The central bank then must adopt a more contractionary monetary policy in order to prevent inflation from exceeding their 2 percent target. The contractionary monetary policy shifts AD back to the left, offsetting the effect of the fiscal stimulus.

– This is called monetary offset.

What would an effective fiscal stimulus look like?

It turns out that fiscal policy could play a role, but only through supply-side channels. Return to the aggregate supply/aggregate demand idea discussed above. If policymakers were able to increase aggregate supply, then the Fed would be under no pressure to offset the effects with tighter monetary policy. That’s because supply-side tax cuts actually tend to lower the inflation rates and raise growth.

– A good example is a cut in the employer-side of the payroll tax, which would encour­age hiring but would not boost wages or prices.

– Indeed, the cost of labor from the firm’s perspective would decline, whereas workers would see no change in take-home pay.

– Some economists believe that cuts in taxes on investment income might also boost aggregate supply.

Policy is most effective if each part of the government focuses on what it does best. That means the Fed should focus on stable monetary conditions.

Meanwhile, the fiscal authorities should focus on the supply side of the economy, creating an environment where the private sector can flourish.

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