Monetary and fiscal policy in the Great Moderation and the Great Recession

Christopher Allsopp and David Vines

No 10894, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: In this paper we argue for a new approach to monetary and fiscal policy. During the Great Moderation, the inflation targeting regime worked well. Central banks used the interest rate to stabilize inflation, and?subject to inflation being controlled?stabilized the level of demand. Fiscal policy exerted discipline over the public-sector deficits, thereby?indirectly?managing the level of public debt. Such ?fiscal housekeeping? worked well, because the monetary authorities were stabilizing the economy. But once private-sector deleveraging led to the Great Recession, and interest rates hit their zero bound, the economy could no longer be managed by monetary policy. Since then, recovery has come to depend on the ?automatic stabilizers?: as output and tax revenues have fallen, public debt has been created, producing the assets which a deleveraging private sector wishes to hold. But the effect has been very gradual. Recovery would have been faster if fiscal policy had been responsible for the restoration of full employment, in an environment which tolerated the necessary rises in public debt. Conversely, policies of austerity, designed to reduce public debt, have slowed the recovery. Growth will not be resumed until the private sector begins to invest strongly again, creating the financial assets which the private sector wishes to hold, thereby enabling public debt to be retired. This has not yet happened because the private sector, correctly, does not believe that macroeconomic policy is capable of sustaining a strong recovery.

Keywords: Fiscal policy; Inflation targeting; Monetary policy; Quantitative easing; Zero lower bound (search for similar items in EconPapers)
JEL-codes: E44 E52 E58 E61 E62 (search for similar items in EconPapers)
Date: 2015-10
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Journal Article: Monetary and fiscal policy in the Great Moderation and the Great Recession (2015)
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