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Optimal Monetary and Fiscal Policy in a Liquidity Trap

In: NBER International Seminar on Macroeconomics 2004

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  • Gauti B. Eggertsson
  • Michael Woodford

Abstract

In previous work (Eggertsson and Woodford, 2003), we characterized the optimal conduct of monetary policy when a real disturbance causes the natural rate of interest to be temporarily negative, so that the zero lower bound on nominal interest rates binds, and showed that commitment to a history-dependent policy rule can greatly increase welfare relative to the outcome under a purely forward-looking inflation target. Here we consider in addition optimal tax policy in response to such a disturbance, to determine the extent to which fiscal policy can help to mitigate the distortions resulting from the zero bound, and to consider whether a history-dependent monetary policy commitment continues to be important when fiscal policy is appropriately adjusted. We find that even in a model where complete tax smoothing would be optimal as long as the zero bound never binds, it is optimal to temporarily adjust tax rates in response to a binding zero bound; but when taxes have only a supply-side effect, the optimal policy requires that the tax rate be raised during the "trap", while committing to lower tax rates below their long-run level later. An optimal policy commitment is still history-dependent, in general, but the gains from departing from a strict inflation target are modest in the case that fiscal policy responds to the real disturbance in an appropriate way.

(This abstract was borrowed from another version of this item.)

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This chapter was published in:

  • Richard H. Clarida & Jeffrey Frankel & Francesco Giavazzi & Kenneth D. West, 2006. "NBER International Seminar on Macroeconomics 2004," NBER Books, National Bureau of Economic Research, Inc, number clar06-1, October.
    This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 0076.

    Handle: RePEc:nbr:nberch:0076

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    1. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings, Federal Reserve Bank of Kansas City, pages 277-316.
    2. Gauti Eggertsson & Michael Woodford, 2004. "Optimal monetary and fiscal policy in a liquidity trap," Discussion Papers 0405-02, Columbia University, Department of Economics.
    3. Alan J. Auerbach & Maurice Obstfeld, 2003. "The Case for Open-Market Purchases in a Liquidity Trap," NBER Working Papers 9814, National Bureau of Economic Research, Inc.
    4. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," Levine's Bibliography 506439000000000384, UCLA Department of Economics.
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    1. Sentence of enduring value
      by pushmedia1 in The Ambrosini Critique on 2009-01-04 22:19:45
    2. Annoying Anti-Stimulus Arguments: Numbers 1 and 2
      by Mainly Macro in Mainly Macro on 2012-01-29 21:26:00
    3. Why anti-stimulus arguments do not apply
      by Lars P Syll in Lars P Syll's Blog on 2012-01-30 09:36:54
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