Optimal fiscal and monetary policy with occasionally binding zero bound constraints

Abstract

This paper studies optimal government spending and monetary policy when the nominal interest rate is subject to the zero lower bound constraint in a stochastic New Keynesian economy. I find that the government chooses to increase its spending when at the zero lower bound by a substantially larger amount in the stochastic environment than it would in the deterministic environment. The presence of uncertainty creates a unique time-consistency problem if the steady-state is inefficient. Although access to government spending policy increases welfare in the face of a large deflationary shock, it decreases welfare during normal times as the government reduces the nominal interest rate less aggressively before reaching the zero lower bound.

Unemployment benefit extensions at the zero lower bound

“…On the other side, the role of fiscal policies has received renewed interest since the transmission mechanisms are highly affected in a liquidity trap. For instance, Christiano et al (2011), Nakata (2013, Carrillo and Poilly (2013) and Erceg and Lindé (2014) documented that the government spending multiplier is greater (than one) when the ZLB on the nominal interest rate binds. Eggertsson (2011) shows that an increase in labor supply when the ZLB binds raises the real interest rate which lowers output.…”

Optimal long-run inflation with occasionally binding financial constraints

“…Using a standard New Keynesian model, Correia et al (2013) study unconventional fiscal policy at the ZLB and show that an appropriate tax policy can overcome the problem of the ZLB without the need for public spending and future commitments to low interest rates. Nakata (2013) shows that, at the ZLB, the government increases its spending by a considerably larger amount in the stochastic environment than in the deterministic environment. Benigno et al (2013) compare the competitive and the social planner allocations in a small open production economy model with an occasionally binding borrowing constraint.…”

The Inflation Bias Under Calvo and Rotemberg Pricing

“…2 Other authors also consider issues relating to the ZLB in models which use Rotemberg pricing, but also introduce extensions such as capital (see Gavin et al (2013), Braun andKorber (2011), Johannsen (2014)), consumption habits (Gust et al (2012) and Aruoba and Schorfheide (2013)), labor market frictions (Roulleau-Pasdeloup (2013)) or fiscal policy (Nakata (2013), Niemann et al (2013) and Johannsen (2014)). …”