Fiscal and Monetary Stabilization Policy at the Zero Lower Bound: Consequences of Limited Foresight

Michael Woodford and Yinxi Xie ()

No 27521, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper reconsiders the degree to which macroeconomic stabilization is possible when the zero lower bound is a relevant constraint on the effectiveness of conventional monetary policy, under an assumption of bounded rationality. In particular, we reconsider the potential role of countercyclical fiscal transfers as a tool of stabilization policy. Because Ricardian Equivalence no longer holds when planning horizons are finite (even when relatively long), we find that fiscal transfers can be a powerful tool to reduce the contractionary impact of an increased financial wedge during a crisis, and can even make possible complete stabilization of both aggregate output and inflation under certain circumstances, despite the binding lower bound on interest rates. However, the power of such policies depends on the degree of monetary policy accommodation. We also show that a higher level of welfare is generally possible if both monetary and fiscal authorities commit themselves to history-dependent policies in the period after the financial disturbance that causes the lower bound to bind has dissipated. Hence forward guidance continues to play an important role in increasing the effectiveness of stabilization policy.

JEL-codes: E52 E63 E7 (search for similar items in EconPapers)
Date: 2020-07
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Note: EFG ME
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Citations: View citations in EconPapers (14)

Published as Michael Woodford & Yinxi Xie, 2021. "Fiscal and Monetary Stabilization Policy at the Zero Lower Bound: Consequences of Limited Foresight," Journal of Monetary Economics, .

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Journal Article: Fiscal and monetary stabilization policy at the zero lower bound: Consequences of limited foresight (2022)
Working Paper: Fiscal and Monetary Stabilization Policy at the Zero Lower Bound: Consequences of Limited Foresight (2021)
Working Paper: Fiscal and Monetary Stabilization Policy at the Zero Lower Bound: Consequences of Limited Foresight (2020)
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