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Fiscal Deficits, Debt, and Monetary Policy in a Liquidity Trap

In: Monetary Policy under Financial Turbulence


  • Michael B. Devereux

    (University of British Columbia)


The macroeconomic response to the economic crisis has revived old debates about the usefulness of monetary and fiscal policy in fighting recessions. Without the ability to further lower interest rates, policy authorities in many countries have turned to expansionary fiscal policies. Recent literature argues that government spending may be very effective in such environments. But a critical element of the stimulus packages in all countries was the use of deficit financing and tax reductions. This paper explores the role of government debt and deficits in an economy constrained by the zero bound on nominal interest rates. Given that the liquidity trap is generated by a large increase in the desire to save on the part of the private sector, the wealth effects of government deficits can provide a critical macroeconomic response to this. Government spending financed by deficits may be far more expansionary than that financed by tax increases in such an environment. In a liquidity trap, tax cuts may be much more effective than during normal times. Finally, monetary policies aimed at directly increasing monetary aggregates may be effective, even if interest rates are unchanged.
(This abstract was borrowed from another version of this item.)

Suggested Citation

  • Michael B. Devereux, 2011. "Fiscal Deficits, Debt, and Monetary Policy in a Liquidity Trap," Central Banking, Analysis, and Economic Policies Book Series,in: Luis Felipe Céspedes & Roberto Chang & Diego Saravia (ed.), Monetary Policy under Financial Turbulence, edition 1, volume 16, chapter 10, pages 369-410 Central Bank of Chile.
  • Handle: RePEc:chb:bcchsb:v16c10pp369-410

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    References listed on IDEAS

    1. Annicchiarico, Barbara & Giammarioli, Nicola & Piergallini, Alessandro, 2012. "Budgetary policies in a DSGE model with finite horizons," Research in Economics, Elsevier, vol. 66(2), pages 111-130.
    2. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Avoiding Liquidity Traps," Journal of Political Economy, University of Chicago Press, vol. 110(3), pages 535-563, June.
    3. Olivier Jean Blanchard & Stanley Fischer, 1989. "Lectures on Macroeconomics," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262022834, July.
    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, vol. 37(5), pages 813-835, October.
    5. Glenn D. Rudebusch, 2009. "The Fed's monetary policy response to the current crisis," FRBSF Economic Letter, Federal Reserve Bank of San Francisco, issue may22.
    6. Evans, Paul, 1991. "Is Ricardian Equivalence a Good Approximation?," Economic Inquiry, Western Economic Association International, vol. 29(4), pages 626-644, October.
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    Cited by:

    1. Cook, David & Devereux, Michael B, 2016. "Exchange rate flexibility under the zero lower bound," Journal of International Economics, Elsevier, vol. 101(C), pages 52-69.
    2. Annicchiarico, Barbara & Giammarioli, Nicola & Piergallini, Alessandro, 2012. "Budgetary policies in a DSGE model with finite horizons," Research in Economics, Elsevier, vol. 66(2), pages 111-130.

    More about this item

    JEL classification:

    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook


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