I promised to
write something on this some time ago, so this post is overdue. It
was inspired by markets in Provence, where I have been for the last
week. (hence lack of posts, and delay in publishing comments).
There are practical
reasons for preferring interest rate changes (when possible) to
changes in government spending as the stabilisation tool of choice,
although the extent to which these are inevitable or just conditional
on current institutional arrangements is an interesting question.
Here I want to give an economic reason for this preference.
Imagine a monetary
economy made up of independent producers, each of whom produces a
unique good, where these goods are exchanged in a market. The
government can be a buyer in this market, and transforms the goods it
buys into useful public goods. Total consumption is what each
producer chooses to buy from other producers in the market, plus the
public goods they receive. Producers have preferences over private
and public goods which are independent of income, and let’s
initially assume that the government provides just the right amount
of public goods so as to achieve the optimum balance between private
and public consumption. Because people can choose to use their income
to buy goods or hold money, there is potentially an aggregate demand
problem.
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.
