What Monetary Policy Does And Why We Need A Fiscal Stimulus

The formula for the macroeconomy is:
Y = C + I + G + NX

Where:
Y = Total Output
C = Consumer Spending
I = Investment
G = Government Spending
NX = Net exports (Export - Imports)

Normally, when the Fed lowers interests rates this makes borrowing cheaper. This in turn makes investment by businesses in new projects more attractive. For example, if a business predicts that a project will return 8%, then it isn't going to borrow money at an interest rate higher than 8%. As the Fed lowers interest rate, more and more projects become viable. Therefore, I goes up.

Furthermore, as interest rates come down consumers are more willing to borrow money to finance their purchases, and less likely to save money because interest rates are so low. So, C goes up as well.

This is the theory behind monetary policy. Lower interest rates. C and I go up. Thus, Y goes up.

An important point to note about monetary policy is often overlooked. It is really about whether to value the present or the future more strongly. Higher interest rates signal that money should be saved for the future, and lower interest rates say spend now. Part of the reason for low savings rate over the last decade is that the Fed has been telling everybody to live like grasshoppers and not ants.

We need a fiscal stimulus right now because monetary policy isn't working all that well, and it's been tapped out. The Fed can't go below zero. So, instead the government is going to increase G.

On the radio last night, I heard the commentator complaining that Obama was going to be indebting our children's children and didn't care. I had several issues with this beyond the hear no evil, see no evil view the commentator took towards the Bush Administration's obvious profligacy. But in reality whether the government borrows money to increase G or the Fed lowers interest rates to increase C and I, both value the present over the future. Both encourage taking on debt for present spending that will be paid back with future income.

There is a difference though. Businesses are better at allocating resources. So, the debt they incur to invest with is more likely to be productive over the long-term than the politically determined spending of the Federal Government. The government can invest in projects that yield long-term benefits. The highway system comes to mind. However, there is a HUGE make-work bias in government stimuli, which erodes much of the economic benefit. And that's only for the projects that are actually productive in the long-term, not pork barrel spending.