Managing a Liquidity Trap: Monetary and Fiscal Policy

Управление ловушкой ликвидности: денежно-кредитная и бюджетно-налоговая политика
Iván Werning
2011-08-01

New Keynesian modelfiscal stimulusliquidity trapoptimal monetary policyzero lower bound
I study monetary and fiscal policy in liquidity trap scenarios, where the zero bound on the nominal interest rate is binding. I work with a continuous-time version of the standard New Keynesian model. Without commitment, the economy suffers from deflation and depressed output. I show that, surprisingly, both are exacerbated with greater price flexibility. I examine monetary and fiscal policies that maximize utility for the agent in the model and refer to these as optimal throughout the paper. I find that the optimal interest rate is set to zero past the liquidity trap and jumps discretely up upon exit. Inflation may be positive throughout, so the absence of deflation is not evidence against a liquidity trap. Output, on the other hand, always starts below its efficient level and rises above it. I then study fiscal policy and show that, regardless of parameters that govern the value of "fiscal multipliers" during normal or liquidity trap times, at the start of a liquidity trap optimal spending is above its natural level. However, it declines over time and goes below its natural level. I propose a decomposition of spending according to "opportunistic" and "stimulus" motives. The former is defined as the level of government purchases that is optimal from a static, cost-benefit standpoint, taking into account that, due to slack resources, shadow costs may be lower during a slump; the latter measures deviations from the former. I show that stimulus spending may be zero throughout, or switch signs, depending on parameters. Finally, I consider the hybrid where monetary policy is discretionary, but fiscal policy has commitment. In this case, stimulus spending is typically positive and increasing throughout the trap.
1
Decomposing spending into opportunistic and stimulus components shows that stimulus can be zero or change sign under discretionary policy, but is typically positive and increasing when fiscal policy is committed.
2
In a continuous-time New Keynesian model without policy commitment, liquidity traps generate deflation and depressed output, both worsening as prices become more flexible.
3
Optimal government spending starts above its natural level at the liquidity trap’s onset, declines over time, and eventually falls below its natural level regardless of fiscal-multiplier parameters.
4
Optimal monetary policy keeps the interest rate at zero during the trap and raises it discretely upon exit; inflation can remain positive throughout.
5
Output under optimal policy begins below its efficient level and subsequently rises above it, so positive inflation does not rule out a liquidity trap.

monetary and fiscal policy in liquidity trap scenarios within a continuous-time New Keynesian model

optimal policy dynamics at the zero nominal interest-rate bound, including inflation, output, government spending, and stimulus spending under discretionary and committed policy

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2011-08-01
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Iván Werning
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