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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. Gauti B. Eggertsson, 2009. "What fiscal policy is effective at zero interest rates?," Staff Reports 402, Federal Reserve Bank of New York.
  2. Michael Woodford, 2010. "Simple Analytics of the Government Expenditure Multiplier," Discussion Papers 0910-09, Columbia University, Department of Economics.
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  14. Burgert, Matthias & Schmidt, Sebastian, 2013. "Dealing with a liquidity trap when government debt matters: optimal time-consistent monetary and fiscal policy," Working Paper Series 1622, European Central Bank.
  15. Sebastian Schmidt, 2013. "Optimal Monetary and Fiscal Policy with a Zero Bound on Nominal Interest Rates," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 45(7), pages 1335-1350, October.
  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, vol. 37(5), pages 813-35, October.
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