We've seen that demand-sided policies always have a trade-off between unemployment and inflation, yet supply-sided policies don't have that same trade-off. Gauti B. Eggertsson, an economist with the Federal Reserve Bank of New York, makes quite
a convincing argument that supply-sided policies may not work when the interest rates are close to zero:
At zero short-term nominal interest rate, tax cuts reduce output. They do so because they increase deflationary pressures. Policies aimed at stimulating aggregate demand work better. These policies include (i) a temporary increase in government spending and (ii) a commitment to inflate. The multiplier of tax cuts goes from positive at positive interest rates to negative once the interest rate hits zero, while the multiplier of government spending not only stays positive but becomes many times larger at the zero bound.
There has been much discussion in recent weeks about a stimulus plan to revive the US economy. Many economists argue that a recovery plan should include aggressive tax cuts. In this paper I show that under the special circumstances which the US is experiencing today — interest rates that are close to zero and deflationary pressures — tax cuts are contractionary in a standard New Keynesian model. Why? Tax cuts cause deflationary pressures in the model and thereby increase the real interest rate. The Fed can’t accommodate this by cutting the Fed Funds rates, since they are already close to zero. Higher real interest rates are contractionary.
Wow... That's a lot of economics! Can you summarize Eggertsson's argument? What are supply-sided policies, and why does he say that supply-sided policies won't work right now? What's the deal with the multipliers? What happens when the real interest rate increases? Why would this be bad for the US economy right now?
