Journal Article

Macroeconomic policy in light of the credit crunch: the return of counter-cyclical fiscal policy?

Simon Wren-Lewis

in Oxford Review of Economic Policy

Published on behalf of The Oxford Review of Economic Policy Ltd

Volume 26, issue 1, pages 71-86
Published in print January 2010 | ISSN: 0266-903X
Published online January 2010 | e-ISSN: 1460-2121 | DOI: http://dx.doi.org/10.1093/oxrep/grp034
Macroeconomic policy in light of the credit crunch: the return of counter-cyclical fiscal policy?

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This paper begins by arguing that the 2007/8 credit crunch does not require a fundamental re-evaluation of monetary policy. The crunch occurred because regulation was too lax, and we need to develop new and more effective tools of regulatory control. To focus on current account imbalances or mistakes in setting interest rates as a prime cause of the credit crunch is unconvincing, and has the danger of diverting attention away from the need to increase financial regulation. The current recession does require a re-evaluation of the role fiscal policy can play when interest rates hit a zero bound. An expansionary fiscal policy is required because monetary policy-makers are reluctant to promise higher future inflation, and the impact of quantitative easing is likely to be small. Although rising debt may place a limit on how much conventional fiscal policy can do, not all expansionary fiscal measures require additional borrowing. There are two important lessons for the future. First, although monetary policy should remain the primary tool to stabilize the business cycle, the combination of fiscal implementation lags and uncertainty means that some precautionary fiscal action may be appropriate during the early phase of some economic downturns. Second, to play this ‘backstop’ stabilization role effectively, a policy that results in the government debt-to-GDP ratio declining (albeit gradually and erratically) in normal times seems appropriate.

Keywords: credit crunch; fiscal policy; government debt; conventional assignment; E61; E62; E65

Journal Article.  8668 words.  Illustrated.

Subjects: Economic Development and Growth ; Public Economics ; Political Economy ; Public Policy

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