Monetary and Fiscal Remedies for Deflation

Alan Auerbach and Maurice Obstfeld

No 10290, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: Prevalent thinking about liquidity traps suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective for achieving macroeconomic stabilization goals. In an earlier paper, we showed that this reasoning does not hold, that open-market operations can provide substantial macroeconomic benefits and facilitate the use of powerful fiscal policy tools even in a liquidity trap. In this paper, we consider an alternative approach that has been suggested for use in a liquidity trap, a scheduled increase in consumption tax rates. We find that such a policy could, indeed, increase short-run consumption, but would be less effective at increasing welfare or accelerating a country's exit from a liquidity trap. Though a variant of this tax policy might induce exit from a liquidity trap, the impact of welfare is negative in this case as well. We also argue that this alternative tax-rate-based approach is subject to more severe credibility problems than the monetary policy approach explored in our original paper.

JEL-codes: E43 E52 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mon
Date: 2004-02
Note: EFG IFM ME PE
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