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Abstract

This paper explores the peculiar credibility problem that a zero bound on the short-term nominal interest rate, the liquidity trap, poses to monetary and fiscal policy. We present a rational expectations model in which the zero bound on short-term nominal interest rates is binding due to deflationary shocks. When the zero bound is binding the Central Bank best achieves its objectives by generating inflation expectations to lower the real rate of interest and stimulate aggregate demand. A discretionary Central Bank that is independent from fiscal policy, however, cannot credibly commit to inflation. The result is a liquidity trap that is characterized by excessive deflation and a negative output gap. This ìdeflation biasî is the opposite of the ìinflation biasî analyzed by Barro/Gordon (1983) and Kydland/Prescott (1977). Turning to fiscal policy, our model implies that if the Central Bank is independent then Ricardian equivalence holds and deficit spending, i.e. tax cuts and debt accumulation, has no effect. Our proposed solution involves abolishing the independence of the Central Bank. If fiscal and monetary policies are coordinated, Ricardian Equivalence fails, and the government can credibly commit to future inflation by deficit spending. As a result it lowers the real rate of return, curbs deflation and increases output. Finally we address what coordination of fiscal and monetary policy might entail in practice. We review the applicability of our model to the current situation in Japan. We then discuss the extent to which the successful policies pursued in Japan during the Great Depression can be rationalized by our model.

Citation

Eggertsson, Gauti B. Committing to Being Irresponsible: Deficit Spending to Escape a Liquidity Trap. Working paper. Princeton University, November 2001.

@techreport{eggertsson2001irresponsible,
  author = {Gauti B. Eggertsson},
  title = {Committing to Being Irresponsible: Deficit Spending to Escape a Liquidity Trap},
  institution = {Princeton University},
  year = {2001},
  month = {November},
  type = {Working paper}
}