circuit — It's baaack: Paul's Japan paper (monetary policy and expectations in an era of low inflation) (trying not to be monkish)

One of the ongoing debates in economic policy these days is the question of whether a central bank alone can be effective at getting an economy out of the doldrums. 

The most famous exposition of the idea that a central bank alone has the ability to boost economic activity is Paul Krugman's paper entitled "It's baaack: Japan's Slump and the Return of the Liquidity Trap" (1998). 

In the paper, Prof. Krugman explains that, in a (hypothetical) world of Ricardian equivalence in which fiscal policy has no effect on the real economy, the central bank can get households and firms to borrow and spend by announcing it will bring about higher inflation in the future.

Prof. Krugman knows that the assumption of Ricardian equivalence is far fetched and unrealistic; he only includes this simplifying and unrealistic assumption to make his point that the central bank alone can stimulate the economy when fiscal policy is unavailable as a policy option (due to policymakers ideological aversion to public spending, the presence of high public debt, etc.). 

Now before I go any further I want to say that I'm a huge fan of Paul Krugman. I think he's one of  the most sensible economic commentators out there and I agree with almost all his views on policy. On the effectiveness of central banks alone to boost economic activity, however, I'm quite skeptical. 

The logic in Prof. Krugman's paper can be summarized as follows:

Fictional Reserve Barking
It's baaack: Paul's Japan paper (monetary policy and expectations in an era of low inflation) (trying not to be monkish)

circuit