Bringing down interest rates with an easier policy on money would boost economic growth and reduce unemployment, but attempting to get rates down through cutting the budget deficit would slow the economy, according to a study conducted for Senator Robert C. Byrd (D-W.Va.).
Byrd asked the Congressional Budget Office to use different economic models to test what would happen to the economy if interest rates were brought down first through an easier monetary policy and secondly through tightening fiscal policy. Pushing for easier monetary policy, the senator has sponsored a bill that would require the Federal Reserve Board to target interest rates consistent with "sustained economic growth and stable prices." The Fed should aim for real interest rates -- that is, after allowing for inflation -- that are positive but not as large as they have been recently, he and the 33 cosponsors of the bill in the Senate argue.
A similar move is under way in the House.
The study, which will be released Monday, uses two different economic models from Data Resources Inc. and one from Wharton Econometric Forecasting Associates Inc. to simulate what would happen if interest rates were cut by one percent, and by 3 percent through changed monetary and fiscal policy.
The CBO staff cautioned that the results should be viewed with "a healthy dose of skepticism." A Democratic staffer on Capitol Hill agreed that the actual numbers produced by the economic models were not that reliable, but said that the simulations indicated in which direction policy changes would work.
President Reagan and others have argued that Congress should cut prospective budget deficits in order to bring down interest rates and allow the economy to grow. Byrd and some other Democrats argue, along with several economists, that raising taxes and cutting spending will depress the economy, even if it does succeed in bringing down interest rates.
What is needed, they say, is a looser monetary policy that will lower interest rates and supply enough money and credit to the economy to allow a strong recovery.
In order to bring rates down by one percentage point, money growth must expand 0.2 to 0.5 percentage points more than otherwise, the models showed. For a 3-point cut in rates, the narrow money measure M1, which includes currency in circulation and all checking accounts, would have to rise by an extra 0.6 to 1.5 percentage points.
Real output would be about one percent higher in 1985 in the first case, according to the economic models and the unemployment rate between 0.3 and 0.5 percentage point lower.
If rates were cut by 3 percentage points the economic models show real output between 2.5 percent and 3.3 percent higher by 1985, and unemployment between one and 2 percentage points lower.
Although there was a wider range in the results from asking the models what the effect would be of reducing interest rates by raising taxes and cutting government spending, the CBO concluded that "the models clearly suggest that real activity would be lowered by a more restrictive fiscal policy."
The main argument used by those who oppose an easier monetary policy is that this will lead to more inflation. The results of the study do not suggest that the faster growth that comes with looser money and lower interest rates would bring much more inflation. However, the CBO staff warns that on one view of how the economy works, "prices could be changed much more rapidly" than the models' results suggest.