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Monetary and fiscal policy in a liquidity trap with inflation persistence

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  • Michau, Jean-Baptiste

Abstract

This paper relies on the new Keynesian model with structural inflation persistence to characterize the optimal monetary and fiscal policy in a liquidity trap. It shows that, with a Phillips curve that is both forward and backward looking, the monetary policy that is implemented during a liquidity trap episode can be sufficient to avoid a depression. The central bank does not need to commit beyond the end of the crisis to get some traction on economic activity. Regarding fiscal policy, inflation persistence justifies some front-loading of government expenditures to get inflation started, such as to reduce the real interest rate. The magnitude of the optimal fiscal stimulus is decreasing in the degree of inflation persistence. Finally, if inflation persistence is due to adaptive expectations, rather than to price indexation, then monetary policy is ineffective while the optimal fiscal stimulus is large and heavily front-loaded.

Suggested Citation

  • Michau, Jean-Baptiste, 2019. "Monetary and fiscal policy in a liquidity trap with inflation persistence," Journal of Economic Dynamics and Control, Elsevier, vol. 100(C), pages 1-28.
    • Handle: RePEc:eee:dyncon:v:100:y:2019:i:c:p:1-28
    DOI: 10.1016/j.jedc.2018.12.006
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    Cited by:

    1. Roulleau-Pasdeloup, Jordan, 2020. "Optimal monetary policy and determinacy under active/passive regimes," European Economic Review, Elsevier, vol. 130(C).

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    More about this item

    Keywords

    Commitment; Inflation persistence; Liquidity trap; Monetary and fiscal policy;
    All these keywords.

    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian; Modern Monetary Theory
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • 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

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