Alice Through the Looking Glass: Strategic Monetary and Fiscal Policy Interaction in a Liquidity Trap

Sanjit Dhami and Ali al-Nowaihi ()

No 07/15, Discussion Papers in Economics from Division of Economics, School of Business, University of Leicester

Abstract: The recent experience with low inflation has reopened interest in the liquidity trap; which occurs when the nominal interest rate reaches its zero lower bound. To reduce the real interest rate, and to stimulate the economy, the modern literature highlights the role of high inflationary expectations. Using the Dixit-Lambertini (2003) framework of strategic policy interaction, we find that the optimal institutional response to the possibility of a liquidity trap has two main components. First, an optimal inflation target given to the Central Bank. Second, the Treasury, who retains control over fiscal policy and acts as leader, is given optimal output and inflation targets. This keeps inflationary expectations sufficiently high and achieves the optimal rational expectations pre-commitment solution. Simulations show that this arrangement is (1) optimal even when the Treasury has no inflation target but follow's the optimal output target and (2) 'near optimal' even when the Treasury follows its own agenda through a suboptimal output target but is willing to follow an optimal inflation target. Finally, if monetary policy is delegated to an independent central bank with an optimal inflation target, but the Treasury retains discretion over fiscal policy, then the outcome can be a very poor one.

Keywords: liquidity trap; strategic monetary-fiscal interaction; optimal Taylor rules (search for similar items in EconPapers)
JEL-codes: E52 E58 E61 E63 (search for similar items in EconPapers)
Date: 2007-10
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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Working Paper: Alice Through the Looking Glass: Strategic Monetary and Fiscal Policy Interaction in a Liquidity Trap (2006)
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