Optimal robust monetary and fiscal policy under uncertainty on the lower bound

Gülserim Özcan and Guido Traficante

Journal of Macroeconomics, 2024, vol. 81, issue C

Abstract: This paper studies robust policy when the policymaker has Knightian uncertainty about the exact position of the effective lower bound (ELB). First, we characterize optimal discretionary policy when a benevolent policymaker controls the nominal interest rate and the level of government spending. Compared to the full information case, an uncertainty-averse policymaker overestimates the level of the ELB, thereby triggering a more aggressive reduction in the nominal interest rate prior to the liquidity trap. Furthermore, the anticipation of a larger increase in public spending improves the trade-off between inflation and the output gap, and dampens the perceived worst-case level of the ELB. As a result, a less conservative fiscal stabilization is desirable to address the uncertainty concerns of the policymaker by partially substituting for the nominal interest rate at the ELB. Moreover, an inflation-conservative policymaker mitigates the impact of uncertainty on equilibrium outcomes even better than a fiscally active policymaker.

Keywords: Monetary policy; Fiscal policy; Discretion; Liquidity trap; Robust control; Knightian uncertainty (search for similar items in EconPapers)
JEL-codes: D81 E52 E58 E62 E63 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jmacro:v:81:y:2024:i:c:s016407042400020x

DOI: 10.1016/j.jmacro.2024.103605

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