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Fiscal activism and the zero nominal interest rate bound

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  • Schmidt, Sebastian

Abstract

I show that the zero nominal interest rate bound may render it desirable for society to appoint a fiscally activist policy-maker who cares less about the stabilisation of government spending relative to inflation and output gap stabilisation than the private sector does. I work with a simple New Keynesian model where the government has to decide each period afresh about the optimal level of public consumption and the one period nominal interest rate. A fiscally activist policy-maker uses government spending more aggressively to stabilise inflation and the output gap in a liquidity trap than an authority with preferences identical to those of society as a whole would do. The appointment of an activist policy-maker corrects for discretionary authorities’ disregard of the expectations channel, thereby reducing the welfare costs associated with zero bound events. JEL Classification: E52, E62, E63

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Paper provided by European Central Bank in its series Working Paper Series with number 1653.

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Date of creation: Mar 2014
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Handle: RePEc:ecb:ecbwps:20141653

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Keywords: discretion; fiscal policy; monetary policy; zero nominal interest rate bound;

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  1. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2011. "When Is the Government Spending Multiplier Large?," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 119(1), pages 78 - 121.
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  3. Gauti B. Eggertsson, 2009. "What fiscal policy is effective at zero interest rates?," Staff Reports 402, Federal Reserve Bank of New York.
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  5. Adam, Klaus & Billi, Roberto M., 2008. "Monetary conservatism and fiscal policy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 55(8), pages 1376-1388, November.
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  7. Schmidt, Sebastian, 2012. "Optimal monetary and fiscal policy with a zero bound on nominal interest rates," IMFS Working Paper Series 53, Institute for Monetary and Financial Stability (IMFS), Goethe University Frankfurt.
  8. Adam, Klaus & Billi, Roberto M., 2007. "Discretionary monetary policy and the zero lower bound on nominal interest rates," Journal of Monetary Economics, Elsevier, Elsevier, vol. 54(3), pages 728-752, April.
  9. David Cook & Michael B. Devereux, 2013. "Sharing the Burden: Monetary and Fiscal Responses to a World Liquidity Trap," American Economic Journal: Macroeconomics, American Economic Association, vol. 5(3), pages 190-228, July.
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  12. Taisuke Nakata, 2012. "Optimal Fiscal and Monetary Policy with Occasionally Binding Zero Bound Constraints," 2012 Meeting Papers, Society for Economic Dynamics 181, Society for Economic Dynamics.
  13. Burgert, Matthias & Schmidt , Sebastian, 2013. "Dealing with a liquidity trap when government debt matters: Optimal time-consistent monetary and fiscal policy," IMFS Working Paper Series 72, Institute for Monetary and Financial Stability (IMFS), Goethe University Frankfurt.
  14. Robert A. Amano & Tony S. Wirjanto, 1998. "Government Expenditures and the Permanent-Income Model," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 1(3), pages 719-730, July.
  15. Eggertsson, Gauti B., 2006. "The Deflation Bias and Committing to Being Irresponsible," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 38(2), pages 283-321, March.
  16. Jung, Taehun & Teranishi, Yuki & Watanabe, Tsutomu, 2005. "Optimal Monetary Policy at the Zero-Interest-Rate Bound," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 37(5), pages 813-35, October.
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