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Optimal Monetary and Fiscal Policy in a Liquidity Trap

Gauti Eggertsson () and Michael Woodford ()

No 10840, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: In previous work (Eggertsson and Woodford, 2003), we characterized the optimal conduct of monetary policy when a real disturbance causes the natural rate of interest to be temporarily negative, so that the zero lower bound on nominal interest rates binds, and showed that commitment to a history-dependent policy rule can greatly increase welfare relative to the outcome under a purely forward-looking inflation target. Here we consider in addition optimal tax policy in response to such a disturbance, to determine the extent to which fiscal policy can help to mitigate the distortions resulting from the zero bound, and to consider whether a history-dependent monetary policy commitment continues to be important when fiscal policy is appropriately adjusted. We find that even in a model where complete tax smoothing would be optimal as long as the zero bound never binds, it is optimal to temporarily adjust tax rates in response to a binding zero bound; but when taxes have only a supply-side effect, the optimal policy requires that the tax rate be raised during the "trap", while committing to lower tax rates below their long-run level later. An optimal policy commitment is still history-dependent, in general, but the gains from departing from a strict inflation target are modest in the case that fiscal policy responds to the real disturbance in an appropriate way.

JEL-codes: E52 E63 (search for similar items in EconPapers)
Date: 2004-10
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-mon
Note: EFG ME
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Published as Eggertsson, Gauti B. and Michael Woodford. "Policy Options In A Liquidity Trap," American Economic Review, 2004, v94(2,May), 76-79.
Published as Optimal Monetary and Fiscal Policy in a Liquidity Trap , Gauti B. Eggertsson, Michael Woodford. in NBER International Seminar on Macroeconomics 2004 , Clarida, Frankel, Giavazzi, and West. 2006

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