Wednesday, September 28, 2011

Two Neglected Phenomena of Modern Macroeconomics

There exists two phenomena which temper the ability of monetary or fiscal policy to encourage growth, and both of these are consistently and wrongly ignored.

  1. Fiscal policy is often said to be effective when businesses or individuals elect to hold large amounts of cash they would normally spend.  The government then essentially forces them to spend this money by taxing / borrowing the money and then spending it on transfer payments or public goods.  What economists neglect, however, is how individuals react to the taxing / borrowing.  If I wish to keep $1,000 under my mattress for protection, and the government taxes me $200 and spends it on infrastructure, spending might not increase.  It is true the government reached under my mattress, yanked $200, and spent it.  But it is also true that I might decrease my normal spending by $200 to bring my cash holding back to $1,000.  Government spending increases $200, but my spending decreased $200.
  2. Monetary policy is not as effective as we think.  When the Fed injects $1 million of "liquidity" into financial markets, economists use the analogy of dropping a million $1 bills from a helicopter.  However, when the Fed gives bankers $1 million, they are taking away treasury bills/bonds worth something close to $1 million.  Consequently, when the Fed prints $1 million, it is false to say spending will increase by $1 million, because bankers gave up, say, $995,000 of wealth in treasury bills/bonds.  In reality, the Fed printed $5,000 and gave it to bankers for free.  And $5,000 is much less than $1,000,000.

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