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Monetary policy and fiscal stimulus with the zero lower bound and financial frictions

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  • Rossana MEROLA

    () (OECD, Economics Department and Université Catholique de Louvain)

Abstract

Recent developments in many industrialized countries have triggered a debate on whether monetary policy is effective when the nominal interest rate is close to zero. When the nominal interest rate hits its lower bound, the monetary authority is no longer in a position to pursue a policy of monetary easing by lowering nominal interest rates further. In this paper, I assess the implications of the zero lower bound in a DSGE model with financial frictions. The analysis shows that in a framework with financial frictions, when the interest rate is at the lower bound, the initial impact of a negative shock is amplified and the economy is more likely to plunge into a recession. I assess whether different macro policies, such as the management of expectations by the central bank or a counter-cyclical fiscal stimulus, may help recover the economy from the recession. I find that the monetary authority might alleviate the recession by targeting the price-level. Fiscal stimulus represents an alternative solution especially when the zero lower bound constraint becomes binding, as fiscal multipliers may become larger than one. In analyzing discretionary fiscal policy, this paper also focuses on two crucial aspects: the duration of the fiscal stimulus and the presence of implementation lags.

Suggested Citation

  • Rossana MEROLA, 2012. "Monetary policy and fiscal stimulus with the zero lower bound and financial frictions," LIDAM Discussion Papers IRES 2012024, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).
  • Handle: RePEc:ctl:louvir:2012024
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    Cited by:

    1. Merola, Rossana, 2015. "The role of financial frictions during the crisis: An estimated DSGE model," Economic Modelling, Elsevier, vol. 48(C), pages 70-82.
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    3. Makrelov, Konstantin & Arndt, Channing & Davies, Rob & Harris, Laurence, 2020. "Balance sheet changes and the impact of financial sector risk-taking on fiscal multipliers," Economic Modelling, Elsevier, vol. 87(C), pages 322-343.
    4. Konstantin Makrelov & Channing Arndt & Rob Davies & Laurence Harris, 2018. "Fiscal multipliers in South Africa: The importance of financial sector dynamics," WIDER Working Paper Series wp-2018-6, World Institute for Development Economic Research (UNU-WIDER).

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    More about this item

    Keywords

    Optimal monetary policy; financial accelerator; lower bound on nominal interest rates; price-level targeting; fiscal stimulus;
    All these keywords.

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • 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

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