If I were to use an analogy to demonstrate the effects of monetary policy and fiscal policy on the economy I would first say the economy is much like a car and GDP is much like the speed at which the car is driving at. The key assumptions are that the car is driving on an infinitely straight highway and it is equipped with 2 accelerator peddles each with its own gearbox. Why 2 accelerator peddles? Well, for this analogy work and to demonstrate the role of fiscal policy we need to separate the public sector from the private sector. This is because the government can individually control its own amount of total spending or savings through the federal budget, and that it acts independently to the private sectors economic activity, we thus separate it into its own accelerator pedal. This is an important assumption as it allows us to explain how fiscal stimulus packages can prevent the economies GDP from collapsing during a recession and how it is possible for the government to run budget surpluses without sending the economy into recession when times are good. This is because during these times the government is doing the opposite of the private sector.
As we learned from Introductory Macroeconomics classes GDP = C+I+G+X-M, we can view one accelerator pedal as the private sectors spending “C+I-M”, and the other as the government’s spending/saving “±G”. Exports “+X” is determined by the spending on our exports by other countries therefore we don’t have an exports pedal, the corresponding analogy is like we are being towed by the other country if our exports are high. Just like how China’s huge surge in demand for our exports helped us escape the GFC rather unscathed, whilst government stimulus couldn’t entirely counter-balance the fall in private sector spending and collapse in demand for borrowed funds. As is the case during a recession when the private sector decides to spend less, start saving and/or deleveraging, it means they have put their gearbox in reverse and therefore the car begins slowing down significantly, not a very good idea on a highway. However the government can decide to intervene by stepping on its own accelerator and/or that we get towed by another car, if these two forces combined are stronger than the speed of the reverse by the private sector than we should see the car remain stable and possibly still accelerating at a slow rate. For countries like the US where they didn’t have an exports boom to save them, the private sector shifted into reverse and the government didn’t implement enough counter-balancing fiscal policy stimulus to avoid the collapse in private sector spending and demand for borrowed funds which resulted in a surge in unemployment and negative GDP growth. Although heavy expansionary monetary policy was applied in the US, the effect it had on the economy was minimal and continues to be that way.
This is because monetary policy acts like the brakes on the economy, it can prevent the economy from going too fast e.g. high inflation or a bubble by increasing interest rates or stepping on the brakes. It can also prevent the economy from going too slow by cutting interest rates or letting go of the existing applied pressure on the brakes. Also monetary policy is also dependent on demand for borrowed funds and banks willingness to supply the funds to be able to conduct expansionary or contractionary monetary policy. A central bank can continue to lower interest rates, but if no one wanted or could borrow than obviously it is like a car sitting idle on your driveway, it will not move if you are only letting go of the brakes. This is completely different to a car with someone accelerating the peddle but with the brakes on to prevent it from moving. Monetary policy cannot make the car go forward it can only slow it down or not slow it down unlike fiscal policy/the accelerator pedals. And we know that the central bank cannot set negative nominal interest rates much like how you cannot let go anymore of the brakes once your foot is off the pedal. These major differences between monetary policy and fiscal policy are crucial to our understanding of how economic policy can work in an economy. Which is why I become sceptical when I hear that another round of Quantitative Easing will lift the US out of recession, or why a 2% inflation target by the Bank of Japan and additional quantitative easing will solve their deflation problems. These arguments are forgetting that monetary policy alone cannot cause 2% inflation or GDP growth when interest rates are already at zero and the private sector has their foot off the pedal or is in reverse. Monetary policy can only ‘allow’ 2% inflation or GDP growth to occur by not raising interest rates, but these situations are dependent on private sector spending and/or demand for borrowed funds which are currently non-existent, which is why I feel fiscal policy would be more appropriate in these cases to fill the gap.
But how does unorthodox monetary policies like quantitative easing work in this hypothetical analogy? To make matters easy I present a graph taken from the 2012 Finch lecture presented by guest speaker Richard Koo, found here.
From the dotted line, it shows that Quantitative easing (red line) failed to influence any significant increase in the money supply (blue) and borrowed funds (green) in the US, although they usually move in line with each other in the past. Mr.Koo explains that it was dueto the collapse in private sector demand for borrowed funds that this excess liquidity failed to increase the money supply and the amount of debt in the economy. In other words it became excess reserves that remained in the financial system as it could not be lent out to the private sector. To put it into perspective of our car analogy, Quantitative Easing is much like Nitrous Oxide, something you would see in The Fast and The Furious movies. Nitrous Oxide can give your car a huge boost in speed by injecting the highly flammable liquid, but it can also be difficult to control and highly dangerous. It also relies on the driver to actually be using the gas pedal, meaning if your car was idle in the driveway and you pressed the Nitrous button, your car wouldn’t move similar to the monetary policy brakes analogy. If private sector spending and demand for borrowed funds was back to its normal state and the central bank decided to conduct quantitative easing, it would create debt fuelled growth/spending which leads to debt bubbles and high inflation.
In the end this hypothetical economy analogy isn’t perfect; for starters it doesn’t explain the possible crowding out effects of government spending during normal times. It also doesn’t explain things that are important to making monetary and fiscal policies such as sovereign debt problems, current account deficits etc. However the key takeaway from this article is that we need to understand how monetary and fiscal policy works and interacts with the state of the economy before we make poor policy choices like implementing austerity measures when the private sector has not recovered and false statements about the outcomes of policies such as QE and inflation targets. The car analogy just provides a simple framework to understand and think about how all of it works.