Some Pleasant Monetarist Arithmetic

Abstract

Sargent and Wallace (1981) are widely regarded to have demonstrated that monetary policy cannot be manipulated independently (exogenously) when the growth path of government expenditures and the tax structure are both fixed. More succinctly, Sargent and Wallace maintain that the only choice available to the central bank is not whether to monetize a government deficit but when—now or later. This result can be viewed as a generalization of the Blinder and Solow (1973, 1974), Tobin and Buiter (1976), and Steindl (1974) analyses of the stationary state when it is assumed that the monetary base is increased while government spending and the tax rate are fixed, so that government borrowing is adjusted passively via open market operations.1 Although Sargent and Wallace's argument appears persuasive to such authors as King and Plosser (1983), I believe it is seriously wrong as a guide to understanding monetary policy in the United States. To prove my point, this paper first demonstrates that whether or not the government can independently manipulate money, spending, and taxes is not a theoretical question. Then I present evidence that, at least in the United States, the government can indeed independently manipulate all three instruments, with government debt adjusting in a passive but stable manner.