Fiscal deficits, debt, and monetary policy in a liquidity trap

Michael Devereux

No 44, Globalization Institute Working Papers from Federal Reserve Bank of Dallas

Abstract: The macroeconomic response to the economic crisis has revived old debates about the usefulness of monetary and fiscal policy in fighting recessions. Without the ability to further lower interest rates, policy authorities in many countries have turned to expansionary fiscal policies. Recent literature argues that government spending may be very effective in such environments. But a critical element of the stimulus packages in all countries was the use of deficit financing and tax reductions. This paper explores the role of government debt and deficits in an economy constrained by the zero bound on nominal interest rates. Given that the liquidity trap is generated by a large increase in the desire to save on the part of the private sector, the wealth effects of government deficits can provide a critical macroeconomic response to this. Government spending financed by deficits may be far more expansionary than that financed by tax increases in such an environment. In a liquidity trap, tax cuts may be much more effective than during normal times. Finally, monetary policies aimed at directly increasing monetary aggregates may be effective, even if interest rates are unchanged.

JEL-codes: E2 E5 E6 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2010
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Note: Published as: Devereux, Michael B. (2011), "Fiscal Deficits, Debt, and Monetary Policy in a Liquidity Trap," in Monetary Policy under Financial Turbulence, ed. Luis Felipe Céspedes, Roberto Change and Diego Saravia (Santiage, Chile: Central Bank of Chile), 369-410.
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Related works:
Chapter: Fiscal Deficits, Debt, and Monetary Policy in a Liquidity Trap (2011)
Working Paper: Fiscal Deficits, Debt, and Monetary Policy in a Liquidity Trap (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:feddgw:44

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