Optimal Monetary and Fiscal Policy in a Liquidity Trap ∗

In previous work (Eggertsson and Woodford, 2003), we characterized the optimal conduct of monetary policy when a real disturbance causes the natural rate of interest to be temporarily negative, so that the zero lower bound on nominal interest rates binds, and showed that commitment to a history-dependent policy rule can greatly increase welfare relative to the outcome under a purely forward-looking inflation target. Here we consider in addition optimal tax policy in response to such a disturbance, to determine the extent to which fiscal policy can help to mitigate the distortions resulting from the zero bound, and to consider whether a history-dependent monetary policy commitment continues to be important when fiscal policy is appropriately adjusted. We find that even in a model where complete tax smoothing would be optimal as long as the zero bound never binds, it is optimal to temporarily adjust tax rates in response to a binding zero bound; but when taxes have only a supply-side effect, the optimal policy requires that the tax rate be raised during the “trap”, while committing to lower tax rates below their long-run level later. An optimal policy commitment is still history-dependent, in general, but the gains from departing from a strict inflation target are modest in the case that fiscal policy responds to the real disturbance in an appropriate way. ∗Prepared for the NBER International Seminar on Macroeconomics, Reykjavik, Iceland, June 18-19, 2004. We would like to thank Pierpaolo Benigno, Tor Einarsson, and Eric Leeper for helpful discussions, and the National Science Foundation for research support through a grant to the NBER. The views expressed in this paper are those of the authors and do not necessarily represent those of the IMF or IMF policy. Recent developments in both Japan and the U.S. have brought new attention to the question of how policy should be conducted when short-term nominal interest rates reach a level below which no further interest-rate declines are possible (as in Japan), or below which further interest-rate declines are regarded as undesirable (arguably the situation of the U.S.). It is sometimes feared that when nominal interest rates reach their theoretical or practical lower bound, monetary policy will become completely impotent to prevent either persistent deflation or persistent underutilization of productive capacity. The experience of Japan for the last several years suggests that the threat is a real one. In a previous paper (Eggertsson and Woodford, 2003), we consider how the existence of a theoretical lower bound for nominal interest rates at zero affects the optimal conduct of monetary policy, under circumstances where the natural rate of interest — the real interest rate required for an optimal level of utilization of existing productive capacity — can be temporarily negative, as in Krugman’s (1998) diagnosis of the recent situation in Japan. We show that the zero lower bound can be a significant obstacle to macroeconomic stabilization at such a time, through an approach to the conduct of monetary policy that would be effective under more normal circumstances. Nonetheless, we find that the distortions created by the zero lower bound can be mitigated to a large extent, in principle, through commitment to the right kind of policy. We show that an optimal policy is history-dependent, remaining looser after the real disturbance has dissipated than would otherwise be chosen given the conditions prevailing at that time. According to our model, the expectation that interest rates will be kept low for a time even after the natural rate of interest has returned to a positive level can largely eliminate the deflationary and contractionary impact of the disturbance that temporarily causes the natural rate of interest to be negative. An important limitation of our previous analysis is that it abstracted entirely from the role of fiscal policy in coping with a situation of the kind that may give rise to a liquidity trap. In the model of Eggertsson and Woodford (2003), fiscal policy considerations of two distinct sorts are omitted. First, in the consideration of optimal policy there, no fiscal instruments are assumed to be available to the policymaker. The sole problem considered