Strategic monetary and fiscal policy interaction in a liquidity trap
AbstractGiven the recent experience, there is growing interest in the liquidity trap; which occurs when the nominal interest rate reaches its zero lower bound. Using the Dixit-Lambertini (2003) framework of strategic policy interaction between the Treasury and the Central Bank, we find that the optimal institutional response to the possibility of a liquidity trap has two main components. First, an optimal inflation target is given to the Central Bank. Second, the Treasury, who retains control over fiscal policy and acts as a Stackelberg leader, is given optimal output and inflation targets. This solution achieves the optimal rational expectations pre-commitment solution. This result holds true for a range of specifications about the Treasury's behavior. However, when there is the possibility of a liquidity trap, if monetary policy is delegated to an independent central bank with an optimal inflation target, but the Treasury retains discretion over fiscal policy, then the outcome can be a very poor one.
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Bibliographic InfoPaper provided by Department of Economics, University of Leicester in its series Discussion Papers in Economics with number 11/43.
Date of creation: Jun 2011
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Find related papers by JEL classification:
- E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
- E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
This paper has been announced in the following NEP Reports:
- NEP-ALL-2012-02-01 (All new papers)
- NEP-CBA-2012-02-01 (Central Banking)
- NEP-MAC-2012-02-01 (Macroeconomics)
- NEP-MON-2012-02-01 (Monetary Economics)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Avinash Dixit & Luisa Lambertini, 2003.
"Interactions of Commitment and Discretion in Monetary and Fiscal Policies,"
American Economic Review,
American Economic Association, vol. 93(5), pages 1522-1542, December.
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- Kenneth N. Kuttner & Adam S. Posen, 2001. "The Great Recession: Lessons for Macroeconomic Policy from Japan," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 32(2), pages 93-186.
- Adam S. Posen, 1998. "Restoring Japan's Economic Growth," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 35.
- Shin-Ichi Nishiyama, 2004. "Inflation Target as a Buffer against Liquidity Trap," Econometric Society 2004 Far Eastern Meetings 568, Econometric Society.
- L. Lambertini & R. Rovelli, 2003. "Monetary and fiscal policy coordination and macroeconomic stabilization. A theoretical analysis," Working Papers 464, Dipartimento Scienze Economiche, Universita' di Bologna.
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