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Expansionary monetary policy causes recessions

Summary:
Imagine a large flat piece of land out West. If a series of rivers run through this land for millions of years, it will create a series of canyons. In order to cross this land, hikers have to trudge up and down, up and down. Not good.Instead assume that a set of giant piles of rock are dumped on this flat land, creating a series of mountains. Hikers must climb up and down these mountains to cross the land. Not good.Suppose you start with a stable monetary policy, and no business cycles. They you start doing tight money every few years, creating a boom and bust cycle in the economy. Not good.Or, suppose you start with a stable monetary policy, and then do a highly expansionary policy every few years. Once again, you create a series of business cycles, booms and

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Imagine a large flat piece of land out West. If a series of rivers run through this land for millions of years, it will create a series of canyons. In order to cross this land, hikers have to trudge up and down, up and down. Not good.

Instead assume that a set of giant piles of rock are dumped on this flat land, creating a series of mountains. Hikers must climb up and down these mountains to cross the land. Not good.

Suppose you start with a stable monetary policy, and no business cycles. They you start doing tight money every few years, creating a boom and bust cycle in the economy. Not good.

Or, suppose you start with a stable monetary policy, and then do a highly expansionary policy every few years. Once again, you create a series of business cycles, booms and recessions. Not good.

Many people understand that contractionary monetary policies can create business cycles, but far fewer understand that expansionary monetary policies are equally likely to create business cycles. (Austrians get it.)

The optimal is roughly 4% growth in NGDP, year after year.

I’m currently not all that worried about the economy overheating, but not because I don’t think it would be all that bad if it did. It would be very bad if the economy overheated, likely creating a recession soon after.

So don’t listen to people making arguments that were already discredited in 1968, that is, people claiming that overheating wouldn’t be that bad because it would help workers to find jobs. The actual risk of an overly expansionary monetary policy is that it would cause a subsequent recession.

Back to geology. You don’t want northern Arizona. You don’t want central Colorado. You want Kansas.

The Fed’s gradually building credibility behind it’s 2% AIT. Keep up the good work!!


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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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