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Optimal Monetary and Fiscal Policy in a Liquidity Trap

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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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10840.

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Date of creation: Oct 2004
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Publication status: published as Eggertsson, Gauti B. and Michael Woodford. "Policy Options In A Liquidity Trap," American Economic Review, 2004, v94(2,May), 76-79.
Handle: RePEc:nbr:nberwo:10840

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  1. Auerbach, Alan J. & Obstfeld, Maurice, 2012. "The Case for Open-Market Purchases in a Liquidity Trap," Center for International and Development Economics Research, Working Paper Series qt4tm5h0s3, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  2. Marc P. Giannoni & Michael Woodford, 2003. "Optimal Interest-Rate Rules: I. General Theory," Levine's Bibliography 506439000000000384, UCLA Department of Economics.
  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. Annoying Anti-Stimulus Arguments: Numbers 1 and 2
    by Mainly Macro in Mainly Macro on 2012-01-29 21:26:00
  2. Why anti-stimulus arguments do not apply
    by Lars P Syll in Lars P Syll's Blog on 2012-01-30 09:36:54
  3. Sentence of enduring value
    by pushmedia1 in The Ambrosini Critique on 2009-01-04 22:19:45
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