At the heart of the Eggertsson-Woodford argument is the idea that economic slack increases with the real interest rate, which is the nominal short-term interest rate minus the expected future inflation rate. If prices and wages were able to adjust to economic conditions instantaneously then the economy would operate at its efficient level and there would be no economic slack.
FISCAL DISCIPLINE... government spending cuts are not likely to do good for the economy. Government spending helps the economy grow. More government spending may lead to more jobs. As people earn money, people spend, inflation may set in but as long as inflation is monitored, it is a healthy thing. Contractionary fiscal policy is always a short-term solution to a macro issue. Effective fiscal and monetary policies should go hand in hand, whether contractionary or expansionary----whichever the condition int he economy may be.
I definitely agree with Paul Louangrath. It is a matter of policy choices. The government might play it safe and satisfy with a lower level of economic growth. Or, the government might take calculated risk by spending more in exchange for a little bit higher level of economic growth. Nonetheless, the government need to bear in mind that at a certain point the economy might overheat and drag down everything in a downward spiral.
Paul: To me, the term 'fiscal discipline' means when the government has a near balanced budget. In other words, when a government's revenue matches its spending.
In this regard, each country is in a different situation. In the USA, the government spending is much higher than its revenue. This has been a problem for many years and has caused a huge national debt. I don't see a feasible solution in the near future. It's a sad situation.
Governments (like people generally) can never get their hands on enough money. The world has gone off the Gold Standard and onto the Dollar Standard. So the world has absorbed much of the excess money printing that has gone on in the U.S. over the past two decades.
Most nations do not enjoy this luxury.
This, combined with the computer-revolution which has made almost every aspect of human material production more efficient has (inadvertently) averted widespread deflation that would have accompanied such dramatic productivity improvement in goods and services.
If we were still using the dollar of 1990 to purchase goods, flat-screen TVs might only cost $50 today!
But should the world move away from the dollar as the worlds reserve currency, and the currency used to trade oil and other imports, a dumping of the U. S. dollar and a massive currency inflation could jolt America sometime in the decades ahead.
Between now and then .... we spend like there is no tomorrow!
Yes, the optimal inflation rate should be low. Also, the optimal interest rate at which banks provide loans should be low so that the cost of external financing of business entities is low. on the other hand, high inflation can get out of the control and turn into hyperinflation, which leads to the economic crisis. Also high interest rates are a factor in the cooling of economic processes. By controlling interest rates, the central bank takes into account the level of the country's economic growth and the level of inflation. deflation and negative interest rates are also unfavorable for both the financial system and the entire national economy.
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