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Don’t ease monetary policy; cut rates instead

Summary:
David Beckworth directed me to a new piece by Jeffrey Frankel: A Trade War is No Reason to Ease Monetary Policy A trade war is a negative supply shock, and central banks cannot counteract the negative effects of current policies on real incomes in the United States, the United Kingdom, and many other countries. Only voters can do that He’s right.  A supply shock does not provide a reason to ease monetary policy, as it’s an adverse supply shock.  The Fed should not boost AD to offset a supply shock.  Rather, it should prevent AD growth from changing by keeping interest rates at the Wicksellian equilibrium rate.  Because a trade war will generally reduce the equilibrium interest rate, the Fed should cut rates to avoid changing monetary policy. PS.  Some (most?) economists

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David Beckworth directed me to a new piece by Jeffrey Frankel:

A Trade War is No Reason to Ease Monetary Policy

A trade war is a negative supply shock, and central banks cannot counteract the negative effects of current policies on real incomes in the United States, the United Kingdom, and many other countries. Only voters can do that

He’s right.  A supply shock does not provide a reason to ease monetary policy, as it’s an adverse supply shock.  The Fed should not boost AD to offset a supply shock.  Rather, it should prevent AD growth from changing by keeping interest rates at the Wicksellian equilibrium rate.  Because a trade war will generally reduce the equilibrium interest rate, the Fed should cut rates to avoid changing monetary policy.

PS.  Some (most?) economists believe that cutting interest rates is equivalent to easing monetary policy.  I find that horrifying.

PPS.  I was not able to read the entire Frankel piece, as it’s limited to subscribers.  But the opening bit is 100% correct.


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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