Assessing the Effects of Monetary and Fiscal Policy.

• Author: Nakamura, Emi

Monetary and fiscal policies are central tools of macroeconomic management. This has been particularly evident since the onset of the Great Recession in 2008. In response to the global financial crisis, U.S. short-term interest rates were lowered to zero, a large fiscal stimulus package was implemented, and the Federal Reserve engaged in a broad array of unconventional policies.

Despite their centrality, the question of how effective these policies are and therefore how the government should employ them is in dispute. Many economists have been highly critical of the government's aggressive use of monetary and fiscal policy during this period, in some cases arguing that the policies employed were ineffective and in other cases warning of serious negative consequences. On the other hand, others have argued that the aggressive employment of these policies has "walk[ed] the American economy back from the edge of a second Great Depression." (1)

In our view, the reason for this controversy is the absence of conclusive empirical evidence about the effectiveness of these policies. Scientific questions about how the world works are settled by conclusive empirical evidence. In the case of monetary and fiscal policy, unfortunately, it is very difficult to establish such evidence. The difficulty is a familiar one in economics, namely endogeneity.

Consider monetary policy. The whole reason for the existence of the Federal Reserve as an institution is to conduct systematic monetary policy that responds to developments in the economy. Every Fed decision is pored over by hundreds of Ph.D. economists. This leaves little room for the type of exogenous variation in policy that is so useful in identifying the effects of policy moves on the economy. For example, the Fed lowered interest rates in the second half of 2008 in response to the developing financial crisis. Running a regression of changes in output on changes in policy in this case clearly will not identify the effect of the monetary policy actions on output since the financial crisis--the event that induced the Fed to change policy--is a confounding factor. The same problems apply when it comes to fiscal policy.

This difficulty has led macroeconomists to use a wide array of empirical methods--some based on structural models, others based more heavily on natural experiments--to shed light on the effects of monetary and fiscal policy. Over the past 10 years, there have been exciting empirical developments on both fronts.

In terms of structural methods, a core idea in macroeconomics is that the degree of price rigidity in the economy is a key determinant of the extent to which monetary and fiscal policy (and other demand shocks) affect the economy. If prices are very flexible, a change in demand from some source--say, the government--will induce prices to rise, and this will crowd out demand from other sources. However, if prices are slow to react, this crowd-out does not occur and aggregate demand increases.

An important innovation in recent years has been the use of large micro datasets that underlie the U.S. consumer, producer, import, and export price indexes to measure the degree of price rigidity in the economy. (2) We were among the first researchers to use these data to characterize price rigidity. (3) One of our main conclusions was that distinguishing between different types of price changes is crucial in mapping workhorse macro models into the data. (4) In particular, a very substantial fraction of price changes are due to temporary sales after which the price returns to its original level. In most workhorse macro models, the frequency of price adjustment directly determines the responsiveness of the...