NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Optimal Monetary and Fiscal Policy in a Liquidity Trap

Gauti B. Eggertsson, Michael Woodford

NBER Working Paper No. 10840
Issued in October 2004
NBER Program(s):   EFG   ME

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.

download in pdf format
   (425 K)

email paper

This paper is available as PDF (425 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX

Document Object Identifier (DOI): 10.3386/w10840

Published:

Users who downloaded this paper also downloaded these:
Eggertsson and Woodford Optimal Monetary and Fiscal Policy in a Liquidity Trap
Iwamura, Kudo, and Watanabe w11151 Monetary and Fiscal Policy in a Liquidity Trap: The Japanese Experience 1999-2004
Eggertsson and Woodford w9968 Optimal Monetary Policy in a Liquidity Trap
Werning w17344 Managing a Liquidity Trap: Monetary and Fiscal Policy
Svensson w10195 Escaping from a Liquidity Trap and Deflation: The Foolproof Way and Others
 
Publications
Activities
Meetings
Data
People
About

Support
National Bureau of Economic Research, 1050 Massachusetts Ave., Cambridge, MA 02138; 617-868-3900; email: info@nber.org

Contact Us