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Optimal monetary and fiscal policy in a liquidity trap

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  • Gauti Eggertsson

    ()
    (Federal Reserve Bank of New York)

  • Michael Woodford

    ()
    (Columbia University - Department of Economics)

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.

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Bibliographic Info

Paper provided by Columbia University, Department of Economics in its series Discussion Papers with number 0405-02.

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Length: 64 pages
Date of creation: 2004
Date of revision:
Handle: RePEc:clu:wpaper:0405-02

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  1. Alan J. Auerbach & Maurice Obstfeld, 2005. "The Case for Open-Market Purchases in a Liquidity Trap," American Economic Review, American Economic Association, vol. 95(1), pages 110-137, March.
  2. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," NBER Working Papers 9419, National Bureau of Economic Research, Inc.
  3. Michael Woodford, 1999. "Commentary : how should monetary policy be conducted in an era of price stability?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 277-316.
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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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