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
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)
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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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