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Expectations-Management

By Matthew Yglesias on November 14, 2009 at 12:58 pm

"Expectations-Management"

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Paul Krugman has spent a lot of time writing about the desirability of more expansionary fiscal policy, but yesterday he seemed to say that this is a second-best alternative to his real preference of something like a Scott Sumner approach to monetary policy:

The first-best answer — that is, the answer that economic models, like my old Japan’s trap analysis, suggest would be optimal — would be to credibly commit to higher inflation, so as to reduce real interest rates.

But the key thing to recognize about this answer is that it’s all about expectations — the central bank only has traction over expected inflation to the extent that it can convince people that it will deliver that inflation after the liquidity trap is over. So to make this policy work you have to (i) convince current policymakers that it’s the right answer (ii) Make that argument persuasive enough that it will guide the actions of future policymakers (iii) Convince investors, consumers, and firms that you have in fact achieved (i) and (ii).

In reality, we haven’t even gotten anywhere near (i): the conventional wisdom is still that any rise in expected inflation above 2 percent is a bad thing, when it’s actually good.

But Krugman thinks this isn’t going to happen. He doesn’t focus on this solution because “I don’t think I’ll get anywhere, at least not until or unless the slump goes on for a long time.” Hence, the focus first on expansionary fiscal policy and now increasingly on direct support for employment.

But if this political analysis is correct, then aren’t the monetary authorities going to end up undermining anything that can be done on the fiscal side? You can see how fiscal policy could be effective as an adjunct to monetary efforts, but if fiscal and monetary policymakers try to work at cross-purposes, then my understanding is that monetary policy wins.

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