Overt Monetary Financing
I will immediately note that some authors use the term "Overt Monetary Financing" for what I consider to be a completely different policy. Modern Monetary Theory (MMT) authors, particularly Bill Mitchell, and Ralph Musgrave (who previously responded to my writing here on this lines) use "Overt Monetary Financing" to refer to what I would call "permanent ZIRP" (zero-interest rate policy).
In permanent ZIRP, the government makes a credible promise to set the policy rate at zero forever, and then the government can finance itself using money or Treasury bills yielding 0% forever. I am not going to debate the wisdom of such a policy here, but I will just note that such a policy involves reducing the power of the central bank, not increasing it. (The mainstream versions of "overt monetary financing" involve giving the central bank more power.)
Why is Fiscal Policy Allegedly Ineffective?The pre-Financial Crisis consensus was that fiscal policy is ineffective with an independent inflation-targeting central bank: any attempt to stimulate growth by fiscal policy would be cancelled out by the central bank. (There is also the debatable question of Ricardian Equivalence, but that is a second order effect,)
(The mainstream consensus is shifting; but this basic principle is still embedded in most DSGE theory, including the Galí paper.)
Therefore, it is not correct to say that the (original) mainstream position was that fiscal policy was ineffective; it's just that the central bank just cancels it out as part of its economic stabilisation mandate. (Please note that I do not agree with that assessment, but that is neither here nor there.)
The "permanent ZIRP" policy would make fiscal policy effective again -- because we have shut down the central bank cancellation. (That said, mainstream economists would scream about the price level jumping to infinity because of expectations.)
Otherwise, with such an analytical framework, "monetary financing" does not look like it would work: the central bank's inflation-targeting mandate would wipe out the effects of "money-financed" fiscal stimulus. (The zero lower bound cannot be used as a cop out; at a zero interest rate, Treasury bills are indistinguishable from money.)
Returning to the Galí PaperThe Galí paper has a lot of mathematics in it, which buries what is happening. In my view, the mathematics provides a good distraction from what the paper says.
The results can be summarised: if the central bank no longer cancels out fiscal policy by following a Taylor Rule, fiscal policy is once again effective. If you accept the assumptions of mainstream economics, that is an obvious result. Furthermore, money financing has nothing to do with the conclusions.
The only reason that money appears within the discussion at all is that the paper assumes that there is a stable relationship between "money" and interest rates via a money demand function. Instead of following a rule setting the policy rate -- a Taylor Rule -- the bank sets the monetary base.
The fact that a mainstream economist is publishing a paper in 2016 which is based upon the concept that "money" is exogenous -- an idea which was thoroughly discredited in the 1980s -- is rather telling. In the real world, no such stable "money demand function" exists, and the policy would only consist of setting interest rates "too low" in order to generate inflation. "Money financing" only appears in the paper because of the use of this discredited theoretical concept.
DSGE Models Have Finance -- Yeah, RightApologists for Dynamic Stochastic General Equilibrium (DSGE) models say that the models have improved after the crisis, and include a financial sector. That argument is disproved by the Galí paper: a banking system is nowhere in sight. In reality, the DSGE modelling framework cannot produce realistic results, and all that can be done is that a particular model can attempt to make one particular improvement, but the improvements are not cumulative -- other things have to be thrown out to make the model tractable. That is, if a financial sector is added to a model, it has to throw out other things.
"Money financing" enthusiasts like Lord Adair Turner write about the monetary base in the real world, and want to consider that to be the same thing as money in a DSGE model. This is an elementary error, but they would need a DSGE model with a banking system to model the distinction. All of the stochastic calculus that the DSGE paper indulge in are a distraction from the fact that they provide exactly zero insight into real world policy decisions.
(c) Brian Romanchuk 2016