Monetary policy and fiscal stimulus with the zero lower bound and financial frictions

Rossana Merola

No 2012024, LIDAM Discussion Papers IRES from Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES)

Abstract: Recent developments in many industrialized countries have triggered a debate on whether monetary policy is effective when the nominal interest rate is close to zero. When the nominal interest rate hits its lower bound, the monetary authority is no longer in a position to pursue a policy of monetary easing by lowering nominal interest rates further. In this paper, I assess the implications of the zero lower bound in a DSGE model with financial frictions. The analysis shows that in a framework with financial frictions, when the interest rate is at the lower bound, the initial impact of a negative shock is amplified and the economy is more likely to plunge into a recession. I assess whether different macro policies, such as the management of expectations by the central bank or a counter-cyclical fiscal stimulus, may help recover the economy from the recession. I find that the monetary authority might alleviate the recession by targeting the price-level. Fiscal stimulus represents an alternative solution especially when the zero lower bound constraint becomes binding, as fiscal multipliers may become larger than one. In analyzing discretionary fiscal policy, this paper also focuses on two crucial aspects: the duration of the fiscal stimulus and the presence of implementation lags.

Keywords: Optimal monetary policy; financial accelerator; lower bound on nominal interest rates; price-level targeting; fiscal stimulus (search for similar items in EconPapers)
JEL-codes: E31 E44 E52 E58 (search for similar items in EconPapers)
Pages: 43
Date: 2012-10-30
New Economics Papers: this item is included in nep-dge, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (7)

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Persistent link: https://EconPapers.repec.org/RePEc:ctl:louvir:2012024

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