Dealing with a liquidity trap when government debt matters: Optimal time-consistent monetary and fiscal policy

Abstract

In 2013 all ECB publications feature a motif taken from the €5 banknote.note: This Working Paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. All rights reserved. ISSN 1725-2806 (online) EU Catalogue NoQB-AR-13-119-EN-N (online)Any reproduction, publication and reprint in the form of a different publication, whether printed or produced electronically, in whole or in part, is permitted only with the explicit written authorisation of the ECB or the authors. AbstractHow does the need to preserve government debt sustainability affect the optimal monetary and fiscal policy response to a liquidity trap? To provide an answer, we employ a small stochastic New Keynesian model with a zero bound on nominal interest rates and characterize optimal time-consistent stabilization policies. We focus on two policy tools, the short-term nominal interest rate and debt-financed government spending. The optimal policy response to a liquidity trap critically depends on the prevailing debt burden. In our model, while the optimal amount of government spending is decreasing in the level of outstanding government debt, future monetary policy is becoming more accommodative, triggering a change in private sector expectations that helps to dampen the fall in output and inflation at the outset of the liquidity trap. Non-technical summaryConfronted with the biggest global economic crisis since decades, policymakers around the world engaged in a combination of monetary and fiscal stabilization policies to fight what has been dubbed the Great Recession. Central banks lowered nominal interest rates to unprecedented low levels and many governments launched fiscal stimulus programs to counteract the economic turmoil. As a consequence, many major industrialized countries experienced protracted increases in government debt-to-GDP ratios. New Keynesian model-based characterizations of optimal monetary and fiscal policies in a liquidity trap, which we define as a situation in which the zero nominal interest rate bound is binding, however, typically omit government debt from the analysis. The standard approach assumes instead that government purchases are completely financed by lump-sum taxes. This raises important questions about the appropriate stance of monetary and fiscal policy: Should policymakers adhere to fiscal stimulus in the face of a zero lower bound event if the level of government debt is already above its long-run target or do high debt burdens require a contractionary fiscal policy response? Likewise, how does the need to ensure debt sustainability act upon the effectiveness of monetary policy? In terms of model-based characterizations of optimal policies at the zero lower bound, is the conventional omission of government debt innocuous or do our normative prescriptions change when we account for the fact that lump-sum taxes in general do not adjust one-to-one with other fiscal variables? We address thes...

Optimal government spending at the zero lower bound: A non-Ricardian analysis

“…I extend their analysis to the models with distortionary taxation and debts. My analysis complements the work of Burgert and Schmidt (2014) and Mateev (2014), who have also studied the implications of debt financing for optimal government spending policy in the model with the ZLB. They assume that the government does not have an explicit commitment technology.…”

Conservatism and Liquidity Traps

“…Eggertsson (2006), Burgert and Schmidt (2014), and Bhattarai, Eggertsson, and Gafarov (2014) considered economies in which the government can choose the level of nominal debt and showed that an increase in government bonds during the liquidity trap improves allocations by creating incentives for future governments to inflate. In a model in which government spending is valued by the household, Nakata (2013) andSchmidt (2013) showed that a temporary increase in government spending can improve welfare whenever the policy rate is stuck at the ZLB.…”

Real Rigidities and Optimal Stabilization at the Zero Lower Bound in New Keynesian Economies

“…We also examine the state-dependency of our results as in Burgert and Schmidt (2014). We …nd that higher initial indebtedness tends to amplify the di¤erences across economies with di¤erent labour market structures.…”

“…Hence, we do not specify dividends D in detail. 7 Notice here that if δ is small enough, it can be fully o¤set by a change in R, leaving the rest of the economy una¤ected.…”