An Exploration of Optimal Stabilization Policy

by N. Gregory Mankiw & Matthew C. Weinzierl

Overview — The researchers explore alternative policy responses to a recession caused by a decline in aggregate demand, the situation affecting the global economy over the last several years. They show that policies that stimulate the economy at the lowest budgetary cost may not be the best policies in terms of well-being, as well-being depends not only on the level of activity but also on the composition of it (due to consumption, investment, and government spending). In their model of the economy, monetary policy is the best response, and if it is sufficient to stop the recession, government spending ought to move in the same direction as private spending. If monetary policy is insufficient or restricted, fiscal policy should try to replicate what monetary policy would do. If that option, too, is restricted, conventional policies that increase government spending are merited. Key concepts include:

The goal of this paper is to address this set of issues in light of modern macroeconomic theory. Unlike traditional Keynesian analysis of fiscal policy, modern macro theory begins with the preferences and constraints facing households and firms and builds from there. Policy is evaluated by how well it raises the welfare of households.
Possible responses to consider, depending on the economic situation at hand, include a reduction of short-term interest rates by the central bank; a reduction in long-term interest rates; creating an investment tax credit or other incentives to entice interest-sensitive investors to spend; and, finally, a package of increased government spending and tax cuts to encourage consumption.
The specific policy conclusions are based on a deliberately simple model, designed to clarify thinking rather than act as a prescriptive solution.

Author Abstract

This paper examines the optimal response of monetary and fiscal policy to a decline in aggregate demand. The theoretical framework is a two-period general equilibrium model in which prices are sticky in the short-run and flexible in the long-run. Policy is evaluated by how well it raises the welfare of the representative household. While the model has Keynesian features, its policy prescriptions differ significantly from textbook Keynesian analysis. Moreover, the model suggests that the commonly used "bang for the buck" calculations are potentially misleading guides for the welfare effects of alternative fiscal policies.