Dealing with a Liquidity Trap When Government Debt Matters: Optimal Time-Consistent Monetary and Fiscal Policy

37 Pages Posted: 3 Jan 2014

See all articles by Matthias Burgert

Matthias Burgert

European Union - Directorate General for Economic and Financial Affairs (DG ECFIN); Goethe University Frankfurt

Sebastian Schmidt

European Central Bank (ECB)

Date Written: December 11, 2013

Abstract

How 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.

Keywords: Monetary and fiscal policy, Deficit spending, Discretion, Zero nominal interest rate bound, New Keynesian model

JEL Classification: E31, E52, E62, E63, D11

Suggested Citation

Burgert, Matthias and Schmidt, Sebastian, Dealing with a Liquidity Trap When Government Debt Matters: Optimal Time-Consistent Monetary and Fiscal Policy (December 11, 2013). ECB Working Paper No. 1622. Available at SSRN: https://ssrn.com/abstract=2366282

Matthias Burgert (Contact Author)

European Union - Directorate General for Economic and Financial Affairs (DG ECFIN) ( email )

BU-1 05/190
Brussels, Bruxelles B-1049
Belgium

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Sebastian Schmidt

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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