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"Does anybody remember all the clever people laughing at Donald Rumsfeld when he first said "unknown unknowns"?"

At least some people were darkly laughing at Rumsfeld because his "knowns" were known to be not what was known.

Speaking of fallacies of composition...

Regarding "the whole of Canada" as a closed system commits a fallacy of composition relative to the whole of Canada as an open system. This is why we need systems theory.

A useful concept here is the Stable Unit Treatment Value Assumption (SUTVA) of the Rubin Causal Model


Basic idea is that outcome of unit 'i' is unaffected by the treatment status of all other units not/i. This rules out externalities of the type Nick describes here.

Kevin: thanks. I saw your tweet, read the Wiki, and updated the post, because I think you are right. Interesting perspective, linking it all together.

Sandwichman: Yep. I would say it this way: what is true for each country may not be true for the world as a whole.

I have a working paper on this topic: [ Link Here NR]

Ryan: Spot on! Good paper, with emphasis on the monetary offset argument.

It's amazing that all those papers get away with it!

Re: Ryan Murphy's working paper:

>> That result is simply arithmetical. The national rate of inflation can be thought of as a weighted average of inflation across regions. If one region pushes its rate of inflation above where it would otherwise be via fiscal stimulus, this necessarily means that the central bank must react such that
disinflation or deflation in the rest of the country occurs so as to hit the central bank’s target overall. If a region is able to force the central bank to overshoot its target, it would raise the question as to why the regional legislative body is more knowledgeable in determining the national inflation target, and why the central bank would fail to take this into consideration in the future.

This conclusion is too strong. Monetary offset only provides that there is an offset, not that it necessarily fully cancels local spending. The net, general equilibrium effect can cancel more or less than all of the local stimulus.

Presume that over the short run, heterogeneous regions have a distinct and slowly changing set of Phillips curves. The Central Bank sees, as this quote points out, a weighted average of inflation over regions giving it an aggregate Phillips Curve, but that curve does not necessarily match that of every (or even any) region.

Under ordinary assumptions, the Phillips curve is a nonlinear function of (local) aggregate demand. If local stimulus pushes a regional economy rightwards/upwards along a "flat" portion of that curve, then the weighted average of inflation seen by the central bank will not change very much, provoking little monetary response. If the stimulus pushes a regional economy along a mostly vertical ("overheated") portion of the curve, then the central bank will instead see a stronger inflation response than one would at first expect.

In fact, once we have heterogeneous regions we can see positive or negative general equilibrium effects from spatial shifts in aggregate demand, even without net fiscal stimulus, because the raw price level can differ between regions.

Imagine WidgetCo relocates its assembly line that produces 1,000 widgets/yr (for export) from Vancouver, a high cost of living area, to rural Nova Scoatia, a low cost of living area. The workers, who relocate to the new area for the sake of argument, still receive exactly the same salaries, but now they pay less for haircuts and rent. A properly-weighted (by deliveries) price index would see a fall in the overall price level/inflation rate, provoking monetary stimulus as "offset."

As an addendum to my comment from yesterday, this point is also related to the usefulness of fiscal transfers in a monetary union: there is a free lunch to be had, in aggregate, by balancing aggregate demand among constituent units.

I apologize for the lateness of my reply but I do have a question/disagreement regarding part of the post.

Why would monetary offset be a relevant reason for believing that the fiscal multiplier is smaller for the whole of Canada? Developing countries today only ever apply national fiscal stimulus when monetary policy has become either unable or unwilling to close the output gap and keep inflation steady. In a sense the fiscal stimulus is seen as a way to bail out monetary policy. When economists try to measure the national multiplier they are looking at how effective fiscal policy will be in helping the central bank meet its goals. I.e. how much fiscal stimulus will be necessary for monetary policy to regain traction with the economy. What use would it be to calculate multipliers when the central bank is unconstrained? Assuming a competent central bank the multiplier will always be fully offset by monetary policy.

A case in point is the specific example used in the blogpost. The new deal was accompanied by expectations of monetary easing since Roosevelt advocated taking the dollar off gold. If anything I think monetary offset should be included as a reason why the whole may be more than the sum of its parts since stimulus that only occurs in some localities will be partly offset by monetary tightening and is (AFAIK) never done in co-ordination with national monetary policy.

Note that none of this criticism applies to Ryan Murphy's (good) paper which focuses on monetary offset in the context of local and state level fiscal policy.

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