Optimal Monetary and Fiscal Policy in a Liquidity Trap / Gauti B. Eggertsson, Michael Woodford.

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Eggertsson, Gauti B

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TextSeries: Working Paper Series (National Bureau of Economic Research) ; no. w10840.Publication details: Cambridge, Mass. National Bureau of Economic Research 2004.Description: 1 online resource: illustrations (black and white)Subject(s):

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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.

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Previous	nber w10838 Inflation Stabilization and Welfare: The Case of a Distorted Steady State /	nber w10839 Optimal Stabilization Policy When Wages and Prices are Sticky: The Case of a Distorted Steady State /	nber w1084 Money, Credit Constraints, and Economic Activity /	nber w10840 Optimal Monetary and Fiscal Policy in a Liquidity Trap /	nber w10841 Dividend Taxes and Corporate Behavior: Evidence from the 2003 Dividend Tax Cut /	nber w10842 The Measurement and Evolution of Health Inequality: Evidence from the U.S. Medicare Population /	nber w10843 External Adjustment /	Next

October 2004.

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.