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Managing a Liquidity Trap: Monetary and Fiscal Policy

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  • Ivan Werning

Abstract

I study monetary and fiscal policy in liquidity trap scenarios, where the zero bound on the nominal interest rate is binding. I work with a continuous-time version of the standard New Keynesian model. Without commitment, the economy suffers from deflation and depressed output. I show that, surprisingly, both are exacerbated with greater price flexibility. I examine monetary and fiscal policies that maximize utility for the agent in the model and refer to these as optimal throughout the paper. I find that the optimal interest rate is set to zero past the liquidity trap and jumps discretely up upon exit. Inflation may be positive throughout, so the absence of deflation is not evidence against a liquidity trap. Output, on the other hand, always starts below its efficient level and rises above it. I then study fiscal policy and show that, regardless of parameters that govern the value of "fiscal multipliers" during normal or liquidity trap times, at the start of a liquidity trap optimal spending is above its natural level. However, it declines over time and goes below its natural level. I propose a decomposition of spending according to "opportunistic" and "stimulus" motives. The former is defined as the level of government purchases that is optimal from a static, cost-benefit standpoint, taking into account that, due to slack resources, shadow costs may be lower during a slump; the latter measures deviations from the former. I show that stimulus spending may be zero throughout, or switch signs, depending on parameters. Finally, I consider the hybrid where monetary policy is discretionary, but fiscal policy has commitment. In this case, stimulus spending is typically positive and increasing throughout the trap.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17344.

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Date of creation: Aug 2011
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Handle: RePEc:nbr:nberwo:17344

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  1. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," NBER Working Papers 7147, National Bureau of Economic Research, Inc.
  2. 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.
  3. Adam, Klaus & Billi, Roberto M., 2004. "Optimal monetary policy under commitment with a zero bound on nominal interest rates," Working Paper Series, European Central Bank 0377, European Central Bank.
  4. 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.
  5. Giovanni Dell'Ariccia & Olivier J. Blanchard & Paolo Mauro, 2010. "Rethinking Macroeconomic Policy," IMF Staff Position Notes, International Monetary Fund 2010/03, International Monetary Fund.
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  1. La trappe à sûreté
    by ? in D'un champ l'autre on 2014-02-24 23:59:00
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Cited by:
  1. Jesús Fernández-Villaverde & Pablo Guerrón-Quintana & Juan F. Rubio-Ramírez, 2011. "Supply-side policies and the zero lower bound," Working Papers 11-47, Federal Reserve Bank of Philadelphia.

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