Some Incomplete Monetarist Arithmetic
My latest post at Pieria looks at modern-day fiscal dominance and its consequences:
In 1981, Sargent & Wallace published their now-famous research paper Some Unpleasant Monetarist Arithmetic. It demonstrated the difficulty that central banks have in controlling inflation when governments are hell-bent on fiscal profligacy. Coming after the fiscal and monetary policy disasters of the 1970s, it seemed like a breath of fresh air. Its recommendation of "monetary dominance" - that fiscal policy-setting should be constrained by the inflation target of the monetary authority - became the standard for "good practice" in macroeconomic management for the next thirty years.
Even today, its shadow lies long. Gavyn Davies recently suggested that the Bank of India needed to establish monetary dominance in order to get inflation under control. And Pozsar and McCulley incorporated its findings into their paper on helicopter money, although they only applied it to the circumstance where inflation was out of control due to fiscal and monetary profligacy. Indeed Sargent & Wallace themselves only apply their analysis to that situation. In effect, they assume that fiscal authorities will always be profligate unless disciplined by a monetary inflation target, and that unconstrained deficit spending will always result in higher inflation.
But the situation in developed countries today is the polar opposite...."
Read on here.