The Monetary Offset

In a recent post, Scott Burns discussed the monetary offset in the context of the Trump administration’s intended fiscal expansion. Given some confusion in the comments, I thought I should offer a clarification.

The term “monetary offset” refers to the idea that, if the monetary authority is targeting inflation or nominal income growth, fiscal policy is either (1) unnecessary or (2) ineffective. If the monetary authority is targeting the appropriate rate of inflation or nominal income growth, aggregate demand shocks will be met with effective monetary policy that offsets the initial shock. In this case, there is no scope for fiscal policy to improve matters. Fiscal policy is unnecessary. If the monetary authority is targeting an inappropriate rate of inflation or nominal income growth, effective fiscal policy will be undermined as the monetary authority adjusts the growth rate of money to hit its inappropriate target. Fiscal policy is ineffective. Any good it might do is offset by poor monetary policy.

The idea that there is a monetary offset has been championed by Scott Sumner and other market monetarists over the last decade. Note, however, that a complete offset only results if the monetary authority is targeting inflation or nominal income growth.

Interestingly, there is no monetary offset if the monetary authority is following Milton Friedman’s k-percent rule, which requires growing the money supply at a constant rate each period. Under such a regime, the monetary authority takes no steps to offset fiscal policy. Old monetarists, like Friedman, argued that fiscal policy was largely ineffective in smoothing out macroeconomic fluctuation. But doing so required stressing the long and variable lags of fiscal policy. They could not argue, as new monetarists do, that fiscal policy will struggle to affect nominal spending.