Monetary vs Fiscal Policy

Professor Bryan Caplan emails me a good question about the short-run effects of monetary and fiscal policy on aggregate demand:

Hey Greg, since you're delving into New Keynesian theory on your blog, I was wondering if you'd weigh in on this:

Suppose the Fed had a rigid policy of 0% monetary growth. Do you think that increasing G or cutting T would have any affect on nominal GDP?

For a particularly stark case, think back to WWII, when the Fed accommodated massive deficits to hold nominal rates close to 0%. What if it had refused to accommodate at all? Would there have even been a nominal GDP expansion? Wouldn't interest rates have skyrocketed, choking off other spending?

Of course, as a textbook writer, you'll recognize that my question is equivalent to asking if the LM curve is vertical. Most economists seem to think that's implausible, but it's not to me. I've never adjusted my cash balances when nominal interest rates changed, and never heard of a person who did. Maybe institutional investors give the LM curve a little slope, but I doubt it's much.

The main reason most economists dismiss the vertical LM story, in my view, is that they aren't doing the right counter-factual. In the real world, fiscal expansion induces monetary expansion, leading to higher nominal GDP. But that's not because deficits are intrinsically expansionary in nominal terms, but because in our political system, monetary authorities feel some pressure to accommodate deficits. In contrast, monetary expansions are expansionary. Even if G and T stayed the same, printing more money raises nominal GDP.

I blogged on this a while back, but got little response.

There is a lot I agree with in Bryan's analysis. In particular, much of the short-run stimulus effect of fiscal policy comes about because it induces a monetary expansion. This monetary expansion is automatic if the Fed is holding the interest rate fixed or if it is following something like a Taylor rule, which is approximately what it is doing now. The effects of fiscal policy would be very different if the Fed were holding the money supply constant in response to a fiscal change.

I disagree with Bryan's suggestion that the LM curve is vertical, however. Introspection is not a particularly reliable way to measure elasticities. There is a substantial empirical literature on money demand that demonstrates that it is interest-elastic. Here is one example from Larry Ball. See his figures 4 and 5. According to Ball, the interest semi-elasticity of money demand is -0.05: This means that an increase in the interest rate of one percentage point, or 100 basis points, reduces the quantity of money demanded by 5 percent.

How far off is the vertical LM case as a practical matter? One way to answer this question is to look at the fiscal-policy multiplier. In chapter 11 of my intermediate macro text, I give the government-purchases multiplier from one mainstream econometric model. If the nominal interest rate is held constant, the multiplier is 1.93. If the money supply is held constant, the multiplier is 0.60. If the LM curve were completely vertical, the second number would be zero. To return to Bryan's WWII example, taking these estimates literally, if the Fed had held the money supply constant rather than keeping interest rates low, the WWII boom would about been about 1/3 as large as it was.