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Stimulus to Heating a House Analogy

June 11, 2014

Aggregate demand is like the temperature in a house.

Monetary policy is like central heating, and the central bank’s target is the thermostat.

Fiscal stimulus is like a space heater.

A recession is like extra cold weather.

When people ask “Can fiscal stimulus increase aggregate demand?”, they are implicitly asking about the central bank.

Does the thermostat not work very well? Translation: Is the central bank bad at hitting the target? Even with a 2% inflation target, would you sometimes get 5% inflation or 2% deflation?

Is it so cold outside that the central heating simply can’t keep up? Translation: Is the recession so bad that no matter how much money the central bank prints, inflation still won’t increase? Keynesians hypothesize that a 0% interest rate might cause this (“liquidity trap”).

Are the space heaters powerful enough to overpower the thermostat, even if it has air conditioning? Translation: Fiscal stimulus can increase aggregate demand, even in the face of contractionary central bank policies like paying interest on reserves.

The banking sector is like a roomate that might prefer a different temperature and changes the thermostat in a clandestine way. Translation: Regulatory capture.

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