Download
Abstract

This dissertation explores optimal monetary and fiscal policy at low nominal interest rates. Policy at low interest rates is challenging since the principal instrument of central banks is the shortterm nominal interest rate and it cannot be set below zero. This can be particularly problematic in adeflationary environment when the government wants to stimulate the economy but is constrained by the zero bound. Recent events in Japan (where the interest rate has been close to zero for the past several years) and the lowest short-term interest rate in the US in the past 45 years make this an urgent topic of research.

The first chapter, joint with Michael Woodford, explores optimal monetary policy under the assumption that the central bank can commit to future policy. The main result is a characterization of optimal policy under commitment. Faced with temporary deflationary shocks that make the zero bound binding, we find that the central bank should commit to lower future interest rates in periods in which the deflationary pressures have subsided and the zero bounds is not binding anymore. This is useful because it creates inflation expectations, thereby lowering the real rate of return and stimulating demand. Furthermore, we show a simple price-level targeting rule that implements this equilibrium.

The second chapter explores the same problem assuming the government cannot commit to future policy. If the only instrument of policy is open-market operations in short-term bonds I show that the inability of the government to commit results in excessive deflation (when government is faced with shocks that make the zero bound binding) relative to the solution when the government can commit to future policy. This is what I call the deflation bias of discretionary policy. I propose several policies to solve this credibility problem.

This third chapter analyses fiscal policy at zero nominal interest rate in alternative institutional frameworks assuming (as in chapter 2) that the government cannot commit to future policy. Real government spending increases demand by increasing public consumption. Deficit spending increases demand by generating inflation expectations. When fiscal and monetary policy are coordinated, deficit is more effective than real government spending in a calibrated model. When the central bank is “goal independent” real government spending is still effective but deficit spending is not.

Citation

Eggertsson, Gauti B. Optimal Monetary and Fiscal Policy and the Liquidity Trap. PhD diss., Princeton University, 2004.

@phdthesis{eggertsson_2004_phd,
  author       = {Eggertsson, Gauti B.},
  title        = {Optimal Monetary and Fiscal Policy and the Liquidity Trap},
  school       = {Princeton University},
  year         = {2004},
  type         = {PhD Dissertation}
}