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It’s now generally accepted that the fiscal stimulus multiplier is roughly zero in countries where the central bank targets inflation.

[Well, at least in graduate level economics, not undergrad textbooks. And of course we live in a world ruled mostly by people who never got beyond undergrad economics.]

Some economists continue to insist that fiscal stimulus can work in the special case where interest rates are stuck at zero. But that argument doesn’t apply if the country is able to do unconventional monetary stimulus such as currency depreciation and/or QE. We haven’t yet figured that out, but the new British government seems to understand:

The independent Office for Budget Responsibility (OBR), which now oversees Treasury forecasts, delivered an encouraging verdict in June on the probable economic impact of the budget. Though it trimmed GDP growth forecasts made on the basis of Labour’s policies, from 1.3% to 1.2% in 2010 and from 2.6% to 2.3% in 2011, the downward adjustment was surprisingly small given Mr Osborne’s accelerated fiscal consolidation.

And why do they think the fiscal austerity will have such a small impact?

In its quarterly take on the economy on August 11th, the Bank of England lowered its growth forecast, but still expects a respectable recovery. Presenting its Inflation Report, Mervyn King, the bank’s governor, played down the importance of Mr Osborne’s extra austerity in the downward revision to growth. The government thinks its harsh fiscal policies will permit more monetary balm, whether through resuming the policy of quantitative easing or keeping interest rates lower for longer. Judging by this week’s report, the central bank is in no mood to tighten policy and takes the view that the rise in inflation will eventually be doused by spare capacity.

Of course in a perfect world the BOE would more than offset the fiscal stimulus, pushing expected NGDP growth even higher. We’re not there yet, but we are moving in the “right” direction.

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This entry was posted on September 18th, 2010 and is filed under Fiscal policy, Misc., Monetary Policy, United Kingdom. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



