Saturday, January 10, 2009

Fiscal Stimulus

In the NYTimes David Brooks discusses the Romer's research showing that monetary policy, not fiscal policy, is the preferred solution to recessions. This is a consistent theme in recent discussion. But what this discussion all ignores is Leijonhufvud's corridor hypothesis, which I discussed in an earlier post. The key point is that the economy works differently when inside the corridor of normal behavior. Then neoclassical relations hold. In depression-like circumstances, on the other hand, we are outside the corridor. It is not at all clear that relationships that hold inside the corridor hold outside as well.

The point of Keynesian economics is thus really about Depression conditions. Then monetary policy is relatively useless because businesses fail to invest not because of the cost of capital but because of fear of the future. It is crucial to keep the corridor analysis in mind these days. Ignoring it is ignoring the Lucas Critique.

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