SYNOPSIS: This piece is a companion to this one and this one, and the three address some critics' false accusations of arithmetic problems in his 4.22.03 NYT piece.

Hey, this is turning into a seminar. Anyway, a bit more about the relationship between liquidity trap or near-trap conditions, fiscal policy, and jobs.

For this one, let's take the price level as given and do a bit of IS-LM. Figure 1 represents the normal state of the economy. The IS curve looks like IS₁, Y_P is potential output, the Fed controls the interest rate. What the Fed will try to do is steer the economy to potential output; in this case, that would require an interest rate of 4 percent. In reality, of course, the Fed never hits the target exactly - lags, uncertainty, etc. - but let's ignore all that.

Now suppose that President Hillary Clinton pushes through a huge public works program. This pushes the IS curve to the right, to IS₂. So output would rise at any given interest rate. But the Fed isn't passive: it will try to offset the fiscal expansion to avert overheating. In this case that would require raising the interest rate to 6. Again, let's ignore the uncertainties: on average, a fiscal expansion will have no effect on output or employment, it will simply lead to higher interest rates.

But there are limits to how low the Fed can push interest rates. Zero is obviously a lower bound: at that point cash dominates securities. The Fed actually sets the bound higher: it believes that pushing rates below 0.75 would drive mutual funds out of business, damaging the financial system's "plumbing". And what happens if 0.75 isn't low enough?

Figure 2 illustrates the situation. Here we assume that the current IS curve, IS₁, is so far to the left that even at a 0.75 percent rate the economy will operate below potential. We already knew from Japan that this was a possibility; now, with the US economy still depressed at a Fed funds rate of 1.25, it has effectively happened here.

In this situation fiscal policy can create jobs. If Hillary's jobs program pushes the IS curve right, to IS₂, it allows the economy to produce at potential.

As I said, we're in that situation now. But it is a very unusual situation, brought on (we think) by special circumstances: an overhang of excess investment in telecoms, an overhang of debt from the boom, investor distrust because of corporate scandals, and general post-bubble retrenchment. The Fed thinks that any day now the IS curve will shift from IS₁ to IS₂ all by itself, as companies start investing again. Others, myself included, are less sure. But most economists think that we will be out of the range in which Fed policy is unable to achieve potential output within a year or two.

As long as 0.75 percent isn't low enough to get to Y_P, fiscal expansion does create jobs. But as soon as the economy has emerged from that situation, and the Fed raises rates above 0.75 percent, fiscal policy doesn't create jobs. We're back to the case in which fiscal expansion drives up interest rates, without a positive effect on employment.

And now, back to the Bush tax cut. It creates jobs, if it does, only while the liquidity trap or near-trap lasts. After that, employment is the same as it would be without the tax cut. So the jobs created in the first year or two go away. Repeat, the jobs go away. OK?

But wait: did I just make this stuff up after the fact, in the face of controversy? No: you can find the same argument - that under normal circumstances the Fed determines the level of employment, regardless of fiscal policy - in my 1997 Slate  piece   on "Vulgar Keynesians".

Originally published on the Official Paul Krugman Page, 4.29.03