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Fiscal or Monetary Policy?

In Gordon and Krenn’s 2010 NBER working paper “The End of the Great Depression 1931-1941: Policy Contributions and Fiscal Multipliers” the authors measure and compare the effects of monetary and fiscal policy in ending the Great Depression. Utilizing a VAR model in their analysis, the authors arrive at the conclusion that 89.1% of the economic recovery that occurred between the first quarter in 1939 and the last quarter of 1941 is due to fiscal policy innovations. The authors attribute 34.1% of the recovery to monetary policy innovations, and the remaining -23.2% to the VAR dynamic forecast and non-governmental factors.

A quick glance at these percentages alludes the reader to the main conclusion of the paper: The recovery from the Great Depression is largely due to changes in fiscal policy, with monetary policy playing a supporting role.

Throughout the course of the paper, the authors outline the contemporary evidence from newspapers and journal articles that illustrate the “explosion of Federal defense expenditures (that) began in 1940:Q2, the quarter in which France fell.” During this period the armament industry arose as the leading player in the U.S. economy, propelling actual output in key American industries well past potential levels.

My main question while reading this paper, however, remained, “What do the results of this study mean for our struggling recovery today in the absence of a 21st century blitzkrieg?” With the fiscal cliff taking a center role in political discussions and balancing the federal budget becoming a high priority, it is highly unlikely that we will experience any increases in government expenditures in the near future.

So where does that leave us? Most likely, we will continue to see a lot more quantitative easing. The recently passed QE3 is a clear indication of this trend. QE3 specifies that the Federal Reserve will buy $40 billion in mortgage-backed securities each month for the remainder of 2012 and maintain low interest rates until mid-2015. Furthermore, the Federal Reserve will continue the $40 billion a month purchases past 2012 if the economy has not shown significant improvement. The open-ended nature of QE3 signifies our nation’s current commitment to economic improvement through monetary policy innovation. However, the fact that the St. Louis Fed economic data reports that the M1 money multiplier has remained below one since the 2008 financial crisis and currently at .901, casts some doubt on whether quantitative easing measures can effectively spur the U.S. economy.


  1. Excellent!
    With the “fiscal cliff” will we see symmetric results? — if stimulative fiscal policy is unusually powerful in a deep recession, will contractionary policy also be more effect? Let’s hope that the lame duck Congress somehow belies its pre-election record and does something. Barring that, let’s hope that this paper does not offer lessons for today!
    Second, in Gordon & Krenn’s analysis, why was monetary policy effective? — our story today would be that (so far) quantitative easing has had effect, and without a change in circumstances — which does not seem to be the case — nor would more of the same. (A caution: if effective, it can take 2-3 quarters before this sort of monetary policy change shows up in GDP aggregates.) Now the Fed doesn’t want to be seen as doing nothing, but that doesn’t mean they think QE3 or a future QE4 would work. That, however, depends on the model they are using. Our H Parker Willis lecturer, Alan Metzler, will likely speak about this issue, and what he believes monetary policy could potentially accomplish.

  2. benton benton

    To your last point about the money multiplier and the ability of monetary policy to spur economic growth, I would point out that much of what the Fed has done since their initial round of quantitative easing has been aimed at boosting liquidity and sentiment in the markets for stressed securities, rather than spurring short term economic growth. Bernanke is an outspoken critic of the Bank of Japan’s handling of their recession in the 90’s-namely that they didn’t respond quickly or aggressively enough to prevent deflation. The commitment to low interest rates in the coming years is a non-traditional policy measure (one of forward guidance) designed to “provide assurance to the market that policy rates will be lower in the future than currently expected” (“Japan’s Deflation and the Bank of Japan’s Experience with Non-traditional Monetary Policy” -Kazuo Ueda) so that we can expect some inflation rather than deflation, which can crush financial institutions capital bases and lead to painful deleveraging. What we have learned from Japan and even the Great Depression is that while the Fed may not be able to increase output in the long run, it can limit the severity of a recession. For output to increase in the long run we need to first provide assurance to the market that things will not get worse, so that financial institutions can resume lending to firms and firms can again invest in their capital and labor stocks.

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