Strategic monetary and fiscal policy interaction in a liquidity trap

Ali al-Nowaihi () and Sanjit Dhami

No 11/43, Discussion Papers in Economics from Division of Economics, School of Business, University of Leicester

Abstract: Given the recent experience, there is growing interest in the liquidity trap; which occurs when the nominal interest rate reaches its zero lower bound. Using the Dixit-Lambertini (2003) framework of strategic policy interaction between the Treasury and the Central Bank, we find that the optimal institutional response to the possibility of a liquidity trap has two main components. First, an optimal inflation target is given to the Central Bank. Second, the Treasury, who retains control over fiscal policy and acts as a Stackelberg leader, is given optimal output and inflation targets. This solution achieves the optimal rational expectations pre-commitment solution. This result holds true for a range of specifications about the Treasury's behavior. However, when there is the possibility of a liquidity trap, 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: 2011-06
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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