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Monetary and fiscal policy in the Great Moderation and the Great Recession

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  • Allsopp, Christopher
  • Vines, David

Abstract

In this paper we argue for a new approach to monetary and fiscal policy. During the Great Moderation, the inflation targeting regime worked well. Central banks used the interest rate to stabilize inflation, and—subject to inflation being controlled—stabilized the level of demand. Fiscal policy exerted discipline over the public-sector deficits, thereby—indirectly—managing the level of public debt. Such ‘fiscal housekeeping’ worked well, because the monetary authorities were stabilizing the economy. But once private-sector deleveraging led to the Great Recession, and interest rates hit their zero bound, the economy could no longer be managed by monetary policy. Since then, recovery has come to depend on the ‘automatic stabilizers’: as output and tax revenues have fallen, public debt has been created, producing the assets which a deleveraging private sector wishes to hold. But the effect has been very gradual. Recovery would have been faster if fiscal policy had been responsible for the restoration of full employment, in an environment which tolerated the necessary rises in public debt. Conversely, policies of austerity, designed to reduce public debt, have slowed the recovery. Growth will not be resumed until the private sector begins to invest strongly again, creating the financial assets which the private sector wishes to hold, thereby enabling public debt to be retired. This has not yet happened because the private sector, correctly, does not believe that macroeconomic policy is capable of sustaining a strong recovery.

Suggested Citation

  • Allsopp, Christopher & Vines, David, 2015. "Monetary and fiscal policy in the Great Moderation and the Great Recession," CEPR Discussion Papers 10894, C.E.P.R. Discussion Papers.
  • Handle: RePEc:cpr:ceprdp:10894
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    Cited by:

    1. Vines, David, 2016. "Chinese leadership of macroeconomic policymaking in a multipolar world," China Economic Review, Elsevier, vol. 40(C), pages 286-296.
    2. Luk, Paul & Vines, David, 2015. "The Optimal Coordination of Fiscal and Monetary Policy in a New Keynesian Framework," CEPR Discussion Papers 10895, C.E.P.R. Discussion Papers.

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    More about this item

    Keywords

    fiscal policy; inflation targeting; monetary policy; quantitative easing; zero lower bound;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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