Dealing with a liquidity trap when government debt matters: Optimal time-consistent monetary and fiscal policy

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. 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.     

Infrastructure provision and macroeconomic performance

This paper studies the differences between private and government provision of infrastructure. Capital utilization decisions and their differential role in determining market prices for capital goods under the two regimes of infrastructure provision serve as a critical transmission mechanism for fiscal policy. A subsidy to private providers of infrastructure is preferable to direct government provision irrespective of how the subsidy or expenditure is financed. The case for private provision is much stronger in economies characterized by high levels of congestion. The choice between private and government provision also has a crucial effect on the design of optimal fiscal policy.     

Reprint to: Infrastructure provision and macroeconomic performance

This paper studies the differences between private and government provision of infrastructure. Capital utilization decisions and their differential role in determining market prices for capital goods under the two regimes of infrastructure provision serve as a critical transmission mechanism for fiscal policy. A subsidy to private providers of infrastructure is preferable to direct government provision irrespective of how the subsidy or expenditure is financed. The case for private provision is much stronger in economies characterized by high levels of congestion. The choice between private and government provision also has a crucial effect on the design of optimal fiscal policy.     

Optimal fiscal and monetary policy with occasionally binding zero bound constraints

This paper studies optimal fiscal and monetary policy when the nominal interest rate is subject to the zero lower bound (ZLB) constraint in a stochastic New Keynesian economy. In the baseline model calibrated to match key features of the U.S. economy, it is optimal for the government to increase its spending when at the ZLB in the stochastic environment by about 60 percent more 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 ZLB.     

Optimal fiscal policy under learning

This paper characterizes optimal fiscal policy when agents learn about future taxation. A benevolent and fully rational government chooses taxes on labor income and state-contingent bonds to finance public spending, considering that private agents form their expectations through a learning algorithm. Facing a trade-off between distortionary taxes and distorted expectations, the Ramsey planner chooses the policy that minimizes the total cost of distortions. The analysis produces two main results. First, the government will use fiscal variables to manipulate expectations, reducing taxes and issuing debt at times of pessimism and doing the opposite at times of optimism. This speeds up learning. Second, the expectation-dependent fiscal plan is also history-dependent, and it prescribes taxes that are not as smooth and more persistent than under rational expectations. These findings are robust to alternative learning algorithms.     

财政货币政策、房价波动与宏观杠杆——基于信心传导机制的分析

利用市场主体信心的微观调查数据,借助仿真情景模拟下的反事实实验方法对信心能否在财政政策和货币政策调控杠杆与房价的过程中发挥作用进行实证分析,而后利用TVP-VAR模型对其内在机制展开深入探讨。研究表明,当信心被虚拟冲击抵消后,政策效果与基准结果呈现明显分化。即信心能够显著影响财政货币政策对杠杆与房价的作用效果,且经进一步实证分析得知信心正向影响于房价、负向影响于宏观杠杆。因此,政府在实施政策调控时,应注意市场预期的引导,在借助信心渠道强化房价调控政策效果的同时,也要关注信心对杠杆调控政策效果的干扰,并注意政策制定的连贯性与稳定性,以及财政货币政策的协调搭配。     

Fiscal and monetary policies in complex evolving economies

What is the most appropriate combination of fiscal and monetary policies in economies subject to banking crises and deep recessions? We study this issue using an agent-based model that is able to reproduce a wide array of macro- and micro-empirical regularities. Simulation results suggest that policy mixes associating unconstrained, counter-cyclical fiscal policy and monetary policy targeting employment is required to stabilise the economy. We also show that “discipline-guided” fiscal rules can be self-defeating, as they depress the economy without improving public finances. Finally, we find that the effects of monetary and fiscal policies become sharper as the level of income inequality increases.     

Briefing Paper: The Interdependence of Fiscal and Monetary Policy under Economic and Monetary Union

This article explores the implications of Economic and Monetary Union (EMU) for the conduct of fiscal policy. Under EMU, where the European Central Bank is successful in controlling inflation, the loss of seigniorage revenues causes a potential problem for public sector deficits. To prevent the debt-income ratio from spiralling upwards, a primary budget surplus is ultimately required. EMU has usually been considered as a strong central monetary authority which forces fiscal discipline on lax national governments. But this is not the only possibility. Because the debt ratio can be reduced by surprise inflation, the price expectations of the private sector are important. Once these are taken into account, EMU can be examined in a 'game' framework in which the reputation of the authorities and the existence or otherwise of cooperation between the fiscal and monetary authorities becomes a critical factor.
The paper finds that where the authorities enjoy reputation and cooperate, a one-off reduction in public spending will lead to a permanent decline in the real interest rate and crowd in extra private spending (consumption and investment). Without reputation the cut in government spending has to be sustained. Where there is neither reputation nor cooperation, the outcome depends on the structure of the European economy and whether fiscal policy can effect the terms of trade between countries. If the terms of trade remain unchanged, the outturn is similar to the case of cooperation without reputation, but where the terms of trade can be improved in one country, there is no incentive to cut public spending. In this case the outturn is higher inflation with private spending crowded out.     

Impacts of Monetary, Fiscal and Exchange Rate Policies on Output in China: A Var Approach

Applying the VAR model and using the interest rate as a monetary policy variable, we find that in the long run, output in China responds negatively to a shock to the interest rate, the real exchange rate, government debt, or the inflation rate, and it reacts positively to a shock to government deficits or lagged own output. When real M2 is chosen as a monetary policy variable, long-term output in China responds positively to a shock to real M2 or lagged own output, and it reacts negatively to a shock to the real exchange rate, government debt, or government deficits. Its response to a shock to the inflation rate is negative when government debt is used and is positive when government deficits are considered. In the short run, fiscal policy is more important than monetary policy in three out of four cases. In the long run, monetary policy is more influential than fiscal policy in three out of four cases. Therefore, the government may consider conducting monetary and fiscal policies differently in the short run and long run. The government needs to be cautious in pursuing deficit spending as its long-term impacts depend on the monetary variable employed. The policy of maintaining a relatively stable exchange rate is appropriate as the depreciation of the Yuan may hurt the economy in the short run.JEL Classifications: E5, F4, H6     

What are the effects of fiscal policy shocks?

We propose and apply a new approach for analyzing the effects of fiscal policy using vector autoregressions. Specifically, we use sign restrictions to identify a government revenue shock as well as a government spending shock, while controlling for a generic business cycle shock and a monetary policy shock. We explicitly allow for the possibility of announcement effects, i.e., that a current fiscal policy shock changes fiscal policy variables in the future, but not at present. We construct the impulse responses to three linear combinations of these fiscal shocks, corresponding to the three scenarios of deficit‐spending, deficit‐financed tax cuts and a balanced budget spending expansion. We apply the method to US quarterly data from 1955 to 2000. We find that deficit‐financed tax cuts work best among these three scenarios to improve GDP, with a maximal present value multiplier of five dollars of total additional GDP per each dollar of the total cut in government revenue 5 years after the shock. Copyright © 2009 John Wiley & Sons, Ltd.     

Growth, debt and public infrastructure

This paper presents a closed economy model of endogenous growth driven by capital externalities arising from both private capital and public infrastructure. The model is calibrated to fit data for India, an approximately closed economy. Simulations suggest that fiscal policy certainly matters and the choice of the income taxation rate, the mix of government spending between infrastructure and public consumption goods, and the long-run government debt/GDP ratio can all significantly affect the long-run growth rate. Intertemporal aspects of fiscal policy are also important and the precommitment (time-inconsistent) and non-precommitment policies differ substantially.     

Lack of confidence,the zero lower bound,and the virtue of fiscal rules

In the presence of the zero lower bound, standard business cycle models with a Taylor-type monetary policy rule are prone to equilibrium multiplicity. A drop in private sector confidence can drive the economy into a liquidity trap without any change in fundamentals. I show, in the context of a standard New Keynesian model, that it is possible to design Ricardian fiscal spending rules that insulate the economy from such expectations-driven liquidity traps. In the case of price adjustment costs, desirable fiscal rules ensure that a drop in confidence does not lead to a decline in real marginal costs. In the case of nominal wage adjustment costs, desirable fiscal spending rules ensure that a drop in confidence does not lead to a decline in the ratio of the marginal rate of substitution between private consumption and hours worked relative to the real wage rate.     

The fiscal and monetary response to COVID‐19: What the Great Depression has – and hasn't – taught us

Although some regard the New Deal of the 1930s as exemplifying an aggressive fiscal and monetary response to a severe economic crisis, the US fiscal and monetary policy responses to the COVID‐19 crisis have actually been far more substantial – and, so far, much more effective in reviving aggregate spending. Although many fear that these responses, and the large‐scale increase in bank reserves especially, must eventually cause unwanted inflation, the concurrent sharp decline in money's velocity has thus far more than offset any inflationary effects of money growth, while forward bond prices reflect a general belief that inflation will remain below 2 per cent for at least another decade. Notwithstanding the growth of the Fed's balance sheet, Fed authorities can always check inflation by sufficiently raising the interest return on bank reserves. Nonetheless, recent developments have heightened the risk of ‘fiscal dominance’ of monetary policy at some point in the future.     

Measuring the effects of fiscal policy

Measuring the effects of discretionary fiscal policy is both difficult and controversial, as some explicit or implicit identifying assumptions need to be made to isolate exogenous and unanticipated changes in taxes and government spending. Studies based on structural vector autoregressions typically achieve identification by restricting the contemporaneous interaction of fiscal and non-fiscal variables in a rather arbitrary way. In this paper, we relax those restrictions and identify fiscal policy shocks by exploiting the conditional heteroscedasticity of the structural disturbances. We use this methodology to evaluate the macroeconomic effects of fiscal policy shocks in the U.S. before and after 1979. Our results show substantive differences in the economy׳s response to government spending and tax shocks across the two periods. Importantly, we find that increases in public spending are, in general, more effective than tax cuts in stimulating economic activity. A key contribution of this study is to provide a formal test of the identifying restrictions commonly used in the literature.     

The policy mix in the US and EMU: Evidence from a SVAR analysis

We use a SVAR approach to the effects of fiscal and monetary policies, as well as their interactions (policy mix) for the US and the Euro Area (EMU). Overall, our results show that these two cases are different from each other. First, while in the case of the US there is evidence of Keynesian monetary policy, the same is not true in the case of the EMU. Second, considering the effects of the global economic and financial crisis, there is evidence of non-Keynesian fiscal policy in the case of the EMU (expansionary fiscal consolidation), while it does not hold in the case of the US. Third, there is evidence supporting the traditional inverse relationship between monetary policy interest rates and inflation in the case of the US, whereas in the case of the EMU there is a price puzzle (frequent in SVAR studies). Fourth, the baseline model seems to be robust in the case of the US, when considering the effects of the economic and financial crisis 2007–2009, while the opposite holds in the case of the EMU. However, in both cases, the policies seem to act as complements. Another similarity appears when analysing the relationship between public spending and taxation, where there is evidence supporting a fiscal retrenchment.     

The Government Spending Multiplier at the Zero Lower Bound: Evidence from the United States

We estimate state-dependent government spending multipliers for the United States. We use a factor-augmented interacted vector autoregression (FAIVAR) model. This allows us to capture the time-varying monetary policy characteristics including the recent zero interest rate lower bound (ZLB) state, to account for the state of the business cycle and to address the limited information problem typically inherent in VARs. We identify government spending shocks by sign restrictions and use a government spending growth forecast series to account for the effects of anticipated fiscal policy. In our baseline specification, we find that government spending multipliers in a recession range from 3.56 to 3.79 at the ZLB. Away from the ZLB, multipliers in recessions range from 2.31 to 3.05. Several robustness analyses confirm that multipliers are higher, when the interest rate is lower and that multipliers in recessions exceed multipliers in expansions. Our results are consistent with theories that predict larger multipliers at the ZLB.     

The Government Spending Multiplier at the Zero Lower Bound: Evidence from the United States

We estimate state‐dependent government spending multipliers for the United States. We use a factor‐augmented interacted vector autoregression (FAIVAR) model. This allows us to capture the time‐varying monetary policy characteristics including the recent zero interest rate lower bound (ZLB) state, to account for the state of the business cycle and to address the limited information problem typically inherent in VARs. We identify government spending shocks by sign restrictions and use a government spending growth forecast series to account for the effects of anticipated fiscal policy. In our baseline specification, we find that government spending multipliers in a recession range from 3.56 to 3.79 at the ZLB. Away from the ZLB, multipliers in recessions range from 2.31 to 3.05. Several robustness analyses confirm that multipliers are higher, when the interest rate is lower and that multipliers in recessions exceed multipliers in expansions. Our results are consistent with theories that predict larger multipliers at the ZLB.     

Monetary policy with interest on reserves

I analyze monetary policy with interest on reserves and a large balance sheet. I show that conventional theories do not determine inflation in this regime, so I base the analysis on the fiscal theory of the price level. I find that monetary policy can peg the nominal rate, and determine expected inflation. With sticky prices, monetary policy can also affect real interest rates and output, though higher interest rates raise output and then inflation. The conventional sign requires a coordinated fiscal–monetary policy contraction. I show how conventional new-Keynesian models also imply strong monetary–fiscal policy coordination to obtain the usual signs. I address theoretical controversies. A concluding section places our current regime in a broader historical context, and opines on how optimal fiscal and monetary policy will evolve in the new regime.     

Learning about fiscal policy and the effects of policy uncertainty

In this paper we ask how uncertainty about fiscal policy affects the impact of fiscal policy changes on the economy when the government tries to counteract a deep recession. The agents in our model are uncertain about the conduct of fiscal policy and act as econometricians by estimating fiscal policy rules that might change over time.We find that assuming that agents are not instantaneously aware of the new fiscal policy regime in place leads to substantially more volatility in the short run and persistent differences in average outcomes. We highlight issues that can arise when a policymaker wants to announce a policy change. From a methodological perspective, we introduce a novel way to model learning in the face of discrete policy changes.     

不同资本账户开放程度下的中国财政货币政策效果分析

研究目标：分析不同资本账户开放程度下的中国财政货币政策效果及福利效应。研究方法：将内生化的政府支出（税收）政策以及包含汇率的价格（数量）型为主的混合货币政策一并纳入一个小型开放的DSGE模型。研究发现：随着资本账户的逐步放开,财政政策方面,减税政策刺激经济增长和促进就业的效果越来越好,政府支出政策刺激经济增长和促进就业的效果越来越差;货币政策方面,国内货币政策的调控效果及利率上升的跨期替代效应减弱。从社会福利损失的角度分析表明：无论是与内生化的政府支出（税收）政策组合还是与财政赤字政策组合,价格型为主的混合货币政策始终优于数量型为主的混合货币政策。研究创新：考察在高、中和低三种资本账户开放背景下中国不同财政货币政策组合的相互作用和经济效应。研究价值：为资本账户放开过程中合理地使用财政货币政策组合提供理论参考。