Message in a Bottle

Tuesday, June 08, 2004

Reagan, Volcker and lots of Inflation

Brad De Long reminds us that Reagans policies weren´t exactly making Volckers job easier
The dominant opinion among macroeconomists is (and for two and a half decades has been: see Sargent and Wallace, "Some Unpleasant Monetarist Arithmetic") that Reagan made Volcker's task of reducing inflation not easier but harder and more costly: the Reagan budget deficits made people worry that the U.S. government might decide to inflate away America's rapidly growing debt, and made it more difficult and expensive for the Federal Reserve to earn the necessary confidence that its low-inflation policies were for real and would be sustained.

Here is what Sargent and Wallace say in their paper:
On the other hand, imagine that fiscal policy dominates monetary policy. The fiscal authority independently sets its budgets, announcing all current and future deficits and surpluses and thus determining the amount of revenue that must be raised through bond sales and seignorage. Under this second coordination scheme, the monetary authority faces the constraints imposed by the demand for government bonds, for it must try to finance with seignorage any discrepancy between the revenue demanded by the fiscal authority and the amount of bonds that can be sold to the public. Although such a monetary authority might still be able to control inflation permanently, it is less powerful than a monetary authority under the first coordination scheme. If the fiscal authority's deficits cannot be financed solely by new bonds, then the monetary authority is forced to create money and tolerate additional inflation.