January 5, 2022
Rochester economist Narayana Kocherlakota explains the difference between the two—and why fiscal policy comes out ahead.
When the country experiences an economic shock that leads to an increase in the unemployment rate and a decline in living standards, the debate begins anew. Politicians, pundits, and the general public grapple with how best to promote economic recovery. Is it, for example, by lowering interest rates or by issuing stimulus checks?
The debate ultimately boils down to a single question: Which is more effective at stimulating a sluggish economy—monetary policy or fiscal policy?
According to Narayana Kocherlakota, there’s a textbook answer, and it’s the wrong one.
Kocherlakota is the Lionel W. McKenzie Professor of Economics at the University of Rochester and a former president of the Federal Reserve Bank of Minneapolis. During a recession, he explains, the longstanding consensus has been to rely on monetary policy by lowering interest rates. Once that approach stops working, there’s typically a switch to fiscal policy, such as issuing stimulus checks. As he points out, once rates get too low, they can’t be cut any further.
In a National Bureau of Economic Research working paper called “Stabilization with Fiscal Policy,” Kocherlakota argues that, contrary to the long-standing consensus view, monetary policy is ineffective at stabilizing the economy during periods of shock. Instead, he presents a model showing that fiscal policy—in the form of stimulus checks for all adults—is actually a more reliable tool.
Narayana Kocherlakota, the Lionel W. McKenzie Professor of Economics. (University of Rochester photo / J. Adam Fenster)
Why is that the case? His reasoning goes like this: During bad economic times, the demand for goods drops because consumers are worried about their financial futures. The goal, then, is to restore that demand. Lower interest rates do stimulate current demand—people find borrowing to be more attractive than saving—but, according to Kocherlakota, lower interest rates create a drag on future demand.
As he explains, “When interest rates are cut, savers earn less income from their financial assets. That means that, in the future, they have less money to spend, which creates a drag on overall future demand. This future drag means that monetary policy is relatively ineffective at fostering fast economic recoveries.”
In contrast, Kocherlakota’s model shows that a fiscal policy approach—such as issuing lump-sum transfers to all consumers—is likely to increase current demand and future demand. The key, according to Kocherlakota, is that the higher transfers won’t increase the country’s tax burden from debt.
“Some economists worry a lot about the government’s going deeper into debt because they believe that the government will have to collect taxes later to pay for it,” says Kocherlakota, the Lionel W. McKenzie Professor of Economics. “But this concern seems out of date, because it ignores how low interest rates have been over the past three decades. The government can readily afford to pay off the costs of additional borrowing simply by issuing more debt.”
Q&A: A closer look at monetary and fiscal policy
Kocherlakota’s findings are best appreciated with a little context. He offers that context by answering some basic questions about monetary and fiscal policy and how they work to support the US economy.
What is monetary policy?
- If it has to do with interest rates, it’s monetary policy. Monetary policy is made by the Federal Reserve.
Monetary policy generally refers to the raising and lowering of interest rates by the Federal Reserve, which is the central bank of the United States. In doing so, the Fed targets what’s called the federal funds rate, which is the overnight interest rate that banks use to borrow and lend to each other.
What happens when the Fed changes the federal funds rate?
- It effects the interest rates that lenders charge to consumers and the interest rates savers can earn on their investments
The federal funds rate is very short term. What matters is what that change signals about the Fed’s actions in the future.
For instance, lenders—as well as all investors—are looking at all financial markets at the same time. Longer term interest rates—like a three-year interest rate—would be affected by how they think the Fed is going to move that overnight rate over the next three years. If they think the rates will go up a lot in the next six months, three-year interest rates will reflect that information. Why do I pick three years? Because that’s a car loan or a layaway plan for furniture. These are the interest rates that start to filter into consumer spending. That’s monetary policy in action.
How do lower interest rates affect savings and investments?
- Lower interest rates can reduce future earnings from savings accounts and investment portfolios.
All these interest rates are interlinked because a bank has the opportunity to save with the Federal Reserve—it serves as a type of bank account—and that affects the interest rate that a bank is willing to pay to depositors or to savers in CD accounts. The higher the interest that the Fed is paying to banks, then the higher interest that banks will end up paying to you and me in our CD account and in commercial deposits—and vice versa. Everything is linked through the mechanisms of people looking for profits in markets. So, if banks think that the Fed is going to be raising rates, they’re going to be willing to buy government bonds or longer-term government bonds.
What are the limitations of monetary policy?
- Interest rates can only be cut so much.
Once interest rates get close to zero, as we’ve seen in the last two recessions here in the US, then the central bank’s ammunition becomes very limited. At that point, the Federal Reserve no longer has the power to cut interest rates to stimulate the economy, and that’s when governments are typically willing to turn to fiscal policy.
What is fiscal policy?
- Fiscal policy refers to changes in tax rates and public spending. Congress sets fiscal policy, with a lot of input from the executive branch.
Fiscal policy is a much broader category than monetary policy. All taxing and spending decisions made by Congress fall into the category of fiscal policy. Those decisions have implications for how much the US borrows, which flows into the deficit and the debt. If Congress raises taxes on the super-rich, that’s fiscal policy. When the government distributes stimulus payments to Americans’ bank accounts, that’s another example of fiscal policy. It can also be a tax or a tariff on a small range of products.
Can fiscal policy and monetary policy be at odds with each other?
- That can happen when the Fed lowers interest rates, while Congress is concerned about adding to the national debt.
Yes. We saw fiscal and monetary policy at odds in the wake of the Great Recession. The initial response—both in 2008 under the Bush administration and then in 2009 under the Obama administration—was fiscal stimulus. The Bush administration facilitated tax cuts through Congress and the Obama administration increased spending. But the recession proved deeper and more protracted than most economists expected. In response to that persistence, the Federal Reserve kept interest rates extraordinarily low, and called desperately for more fiscal stimulus. Instead, Congress cut back on spending. What we saw was Congress and the Fed moving in opposite directions—and an example of politics playing its role in fiscal policy. Why did Congress cut spending? Because as elected officials they were very concerned about the perceived fear among voters that increased spending would run up the deficit and lead to higher debt.
What are the limitations of fiscal policy?
- Increased government spending can add to the national debt, but the implications aren’t clear cut.
The issue of the debt and deficit is very complicated, but to boil it down, in 1973, Robert Barro, then a professor here at Rochester (now at Harvard), wrote a paper called “Are Government Bonds Net Wealth?” He called into question the long-term consequences of handing out money in order to increase consumer demand. Barro pointed out that the government is going to have to pay that back at some point. The question he posed, then, is how will those expectations of future taxes offset the effects of stimulus payments today? Do these factors exactly offset each other? Almost certainly not. But then how much do the expectations of future taxes influence—or undercut—an attempt to provide stimulus?
This has been a very active debate among academics. But my own work points out that, if interest rates are low enough, the government won’t have to raise taxes in the future. In this kind of low-interest world, recipients of government stimulus payments (like those made in April 2020 and April 2021) should not expect to pay higher taxes in the future.
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