Moreover, this really goes to a distinction that people are often not careful about (I was trying to make this point in the discussion of your 'why fiscal policy won't work competition'). We need to decide on what we mean for fiscal stimulus to "work". There are two distinct questions:1) Can fiscal policy increase output in a liquidity trapped economy? Clearly yes.2) Can fiscal policy end the recession, break the trap? Only by increasing expected inflation which could also be done by monetary policy (and doing it with monetary policy is clearly the better way).
- Monetary policy has run out now anyway
- Fiscal policy can achieve economic adjustment in a different way, by creating investment in public goods and increasing expectations of future aggregate demand
First, Peston's £220 billion figure for new gilt issuance. He claims that this will be the same again next year because the government won't cut spending or raise taxes. Wrong! The reason it got so high this year is not because of increased spending or reduced taxes: it is because of the automatic impact of the recession, mainly on tax receipts. The British public deficit is highly sensitive to recessions for various reasons. In fact, most economists think an economic recovery is either already underway, or is about to be, and so the deficit will automatically shrink. I would expect next year's borrowing figure to be at least a third less than this year's even with no policy changes.
- Adjustment of prices to a new full employment equilibrium (more or less the monetarist viewpoint - inflation makes this adjustment much easier because most individual prices and wages will not adjust downwards, so instead you adjust the general price level upwards to compensate)
- Satisfying the demand for excess saving by increasing the money supply (printing money) and thus forestalling the paradox of thrift
- Getting out of a 'sunspot' or a low-output equilibrium by raising expectations of future demand, therefore encouraging people to spend more (the Keynesian multiplier effect)
- Directly increasing aggregate demand, creating investment opportunities which absorb the desired savings of the private sector (either because the public sector invests directly - the US fiscal stimulus case - or because the private sector finds more opportunities to invest)