Functional Finance in Rome and Kansas City

Arjun and I have continued to work on our project on fiscal and monetary policy, which develops the simple — but strangely overlooked [1] — point that both the level of output and the trajectory of the public debt-GDP ratio are jointly determined by both the government budget balance and the interest rate set by the monetary authority. (An early stage in our thinking on this was the subject of a post on this blog last year.) Part of our argument is that the fiscal space metaphor is backward — that the case for countercyclical fiscal policy gets stronger, not weaker, when debt ratios are already high. I’m hoping there will be a working paper version of this soon. But in the meantime, the work is getting presented at various places — by me at the Eastern Economic Association this past spring, by both of us at the International Economics Association in June, by Arjun at an OECD conference in Rome earlier this week, and by me at the University of Missouri at Kansas City tomorrow. If you’re interested, here are our current slides.

[1] This paper by Michael Woodford, which I haven’t yet had time to read properly, seems to have a similar starting point but ends up somewhere quite different.

6 thoughts on “Functional Finance in Rome and Kansas City”

  1. I don't pretend to fully understand this, having last studied economics 39 years ago. But having glanced at your slides, I wondered if you'd looked at data from any countries other than the US ?

  2. No, and this is an important shortcoming we hope to fix down the road.

    I should say, though, that this analysis only applies to countries where the central bank is able to control the market interest rate. That means the US, the EU as a whole, Japan, China (but this approach is not really relevant there) and maybe one or two others. For smaller and poorer countries, the key target is not output or the public debt ratio but the balance of payments, and it may not make sense to think of the interest rate as a policy variable.

  3. The macroeconomic history of the UK through the 1960s and 1970s is repeated episodes of expansionary policy running up against balance of payments constraints. So there's reason to doubt that they have enough space for autonomous interest rate policy. On the other hand, there is no foreign-denominated public debt in the UK. So, I'm not sure.

  4. For much of the 60s and 70s, we were still in the era of fixed exchange rates. Do the balance of payments constraints disappear under floating exchange rates ? Or do they just take other forms ? For example, the sectoral balances people point out that with a UK current account deficit of 4%, the attempt to balance the government budget has interesting implications for the private sector. Sorry, I'm rambling…

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