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Managing a Liquidity Trap: Monetary and Fiscal Policy

  • Ivan Werning

    (Massachusetts Institute of Technology)

I study monetary and fiscal policy in liquidity trap scenario, where the zero bound on the nominal interest rate is initially binding. I adopt a continuous-time formulation of the standard New Keynesian model, which allows for an intuitive, graphical analysis and produces some novel results. Without commitment the economy suffers from deflation and depressed output. Perhaps counterintuitively, both are exacerbated with greater price flexibility. Turning to optimal monetary policy, I find that the interest rate should be kept at zero past the liquidity trap. I also show that inflation may be positive throughout. Thus, the absence of deflation is not evidence against a liquidity trap, but may actually be an optimal response to it. Output, on the other hand, always starts below its efficient level and rises above it. Finally, I study fiscal policy and show that, regardless of parameters that underlie estimated "multipliers", at the start of a liquidity trap spending be above its natural level. However, I also show that spending should declines and go below its natural level before returning to zero. I then decompose spending into its "opportunistic" and "stimulus" motives. The former is the optimal level of government purchases from a static, cost-benefit standpoint; the latter measures deviations from the former. I show that, at the start of a liquidity trap, optimal stimulus spending may be positive or negative.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1435.

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Date of creation: 2011
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Handle: RePEc:red:sed011:1435
Contact details of provider: Postal: Society for Economic Dynamics Christian Zimmermann Economic Research Federal Reserve Bank of St. Louis PO Box 442 St. Louis MO 63166-0442 USA
Fax: 1-314-444-8731
Web page: http://www.EconomicDynamics.org/society.htm
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  1. Klaus Adam & Roberto M. Billi, 2005. "Optimal monetary policy under commitment with a zero bound on nominal interest rates," Research Working Paper RWP 05-07, Federal Reserve Bank of Kansas City.
  2. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2009. "When is the government spending multiplier large?," NBER Working Papers 15394, National Bureau of Economic Research, Inc.
  3. 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 813-35, October.
  4. Clarida, R. & Gali, J. & Gertler, M., 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Working Papers 99-13, C.V. Starr Center for Applied Economics, New York University.
  5. Olivier Blanchard & Giovanni Dell'Ariccia & Paolo Mauro, 2010. "Rethinking Macroeconomic Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 199-215, 09.
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