A note on the ineffectiveness of monetary stimulus (updated and corrected)
A commenter on the previous post raised the idea, promoted by the “market monetarist” school, that monetary policy is so effective as to make fiscal policy entirely unnecessary, at least when interest rates are above the zero lower bound. My views on this issue were formed by the experience of the late 20th century, and in particular, the recession that began in 1990, following steep increases in interest rates. Having planned a “short, sharp, shock”, the RBA started cutting rates in January 1990.
They didn’t go for 25 basis point moves in those days. Over the period to March 1993, rates were cut by more than 12 percentage points, from 17.5 per cent to 5.25 per cent. Over the same period, unemployment rose from 6 per cent to nearly 11 per cent, a record for the period since the Depression, and stayed around that level well into 1994, until the adoption of the Working Nation package of
fiscal stimuuls active labour market policies. As I said in the previous post, tight monetary policy can reliably cause recessions, but expansionary monetary policy in a deep recession is “pushing on a string”.
Update As pointed out by Mark Sadowski in comments, these are nominal rates of interest. To get the real rate, which is more relevant, you need to subtract the expected rate of inflation, which fell from around 7 per cent to around 4 per cent over this period (as measured by surveys, and by the premium for inflation-adjusted Treasury bonds). So, you get a 9 percentage point reduction in the real rate from 10 per cent to 1 per cent. This doesn’t make much difference to the story. Most economists would regard policy as contractionar/expansionary if real interest rates are above/below the long-run neutral level, about 3 per cent. So, we still have a shift from strongly contractionary to moderately expansionary.
However, market monetarists want to argue that the stance of policy should be assessed relative to a policy rule (Taylor rule or NGDP) that already incorporates a prescription of cutting rates when GDP falls and unemployment rises. This doesn’t make a lot of sense to me. It’s like arguing that Obama’s stimulus was actually a contractionary policy because it wasn’t as big as (according to a standard analysis based on Okun’s Law) it should have been. It’s partly a question of semantics, but it’s associated with the claim that, if only rates had been cut even more, we wouldn’t have had the recession, or would have recovered quickly. Having been around at the time, I disagree.