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Extract from paper
In responding to the COVID-19 pandemic, policy makers in advanced economies delivered extraordinary fiscal and monetary policy support. Central banks lowered their policy rates as far as they could – hitting the effective lower bound (or ELB). But the risk that shutdowns would create a deep and prolonged slump led policymakers to deliver further stimulus through the deployment of unconventional or alternative monetary policy tools, and through large increases in fiscal deficits. In New Zealand, measures to contain the virus, combined with alternative monetary policy tools and fiscal support, including a wage subsidy scheme, have contributed to an economic recovery that is among the most vigorous in the world. These developments have taken place against a backdrop of a substantial decline in global interest rates over recent decades. The forces driving this decline, which include population ageing and slower productivity growth, are likely to keep interest rates low, on average, over the years ahead. One obvious and significant implication of persistently low interest rates is an increased likelihood of future episodes where the lower bound constrains the ability of central banks to lower their policy interest rates. Alternative monetary policy tools have a role to play in meeting the challenge of providing the desired stimulus, and there is a case for short-term fiscal support.
This paper contributes to the Treasury’s Macroeconomic Framework Review through a discussion of the effects of fiscal stimulus when monetary policy is constrained by the lower bound. It supplements the recent work of Lyu (2021) that considers the effects of fiscal policy on economic activity in normal times (that is, when monetary policy is unconstrained), and Bernstein et al (2021) that discusses ways to achieve a greater stabilisation role for fiscal policy and the challenges of doing so. Further papers, looking at different aspects of monetary and fiscal policy, are intended as the Review continues.
The paper explores the international research on the effectiveness of fiscal policy stimulus that has emerged in the wake of the GFC. This research highlights the complementary role of fiscal stimulus when monetary policy is constrained by the lower bound. Key research findings include: fiscal stimulus can be an effective means to mitigate falls in output and incomes and it can help monetary policy meet its price stability and employment objectives; fiscal stimulus is more potent when monetary policy is constrained by the ELB, compared to when it is not; the most effective forms of fiscal stimulus contribute directly to demand for labour and capital, such as spending on health and infrastructure, but are generally not well-suited to short-term manipulation; and in practice, the most effective forms of fiscal support tend to be those that are focused on supporting the incomes of households most likely to spend the stimulus payments.
The note begins with a discussion of the key concepts that underpin the recent research. It draws on this research to highlight the role of fiscal stimulus when the lower bound binds, noting the role the exchange rate plays. While the research focuses on the short-run effectiveness of fiscal stimulus, it also produces some conjectures on the longer-run implications for economic growth. The paper concludes with suggestions for the next steps to develop the Treasury’s understanding of the appropriate role of fiscal policy in a low interest rate, low inflation environment.
- Largely over the past decade or so, there has been a substantial decline in estimates of global and domestic neutral interest rates, that is, the interest rate that on average, over time, would be consistent with price stability and maximum sustainable employment.
- Lower neutral rates have limited the extent of conventional policy rate cuts that central banks can deliver when faced with weaker economic conditions. To overcome the constraint of the effective lower bound on interest rates, central banks have adopted new tools and governments have drawn upon their fiscal resources. These novel responses and their interactions are at the centre of policy debates on macroeconomic stabilisation policies.
- A key lesson from the research is that fiscal stimulus can be an effective means to mitigate falls in output and incomes and it can help monetary policy meet its price stability and employment objectives.
- The effectiveness of fiscal stimulus at the ELB depends on the details of the stimulus, including the types of spending or taxes that change, the duration of the change and the duration of the ELB episode, expectations of future fiscal policy and the expected monetary policy response to rising inflation.
- The most effective forms of fiscal stimulus contribute directly to demand for labour and capital, such as spending on health and infrastructure, but there may be practical limits on how much can be achieved in the short run. In practice, the most effective forms of short-term fiscal stimulus tend to be those that are focused on supporting lower income households, which typically have a higher propensity to spend.
- Government stimulus spending is most effective when private demand is weak. When normal monetary policy resumes, continued stimulus may crowd out private demand, reducing its effectiveness.
-  Sometimes referred to as the zero lower bound, the ELB, while typically near-zero, more accurately describes the limits to conventional monetary experienced by central banks. Some central banks have reduced their policy rates to zero, others including the Reserve Bank of New Zealand to date, have maintained a rate a little above zero. Other central banks have been able to set their policy rates a little below zero, an unconventional or alternative approach to monetary policy management.