Hot new research from Iván Werning:
I study monetary and ﬁscal policy in liquidity trap scenarios, where the zero bound on the nominal interest rate is binding. I work with a continuous-time version of the standard New Keynesian model. Without commitment the economy suffers from deﬂation and depressed output. I show that, surprisingly, both are exacerbated with greater price ﬂexibility. I examine monetary and ﬁscal policies that maximize utility for the agent in the model and refer to these as optimal throughout the paper. I ﬁnd that the optimal interest rate is set to zero past the liquidity trap and jumps discretely up upon exit. Inﬂation may be positive throughout, so the absence of deﬂation is not evidence against a liquidity trap. Output, on the other hand, always starts below its efﬁcient level and rises above it. I then study ﬁscal policy and show that, regardless of parameters that govern the value of “ﬁscal multipliers” during normal or liquidity trap times, at the start of a liquidity trap optimal spending is above its natural level. However, it declines over time and goes below its natural level. I propose a decomposition of spending according to “opportunistic” and “stimulus” motives. The former is deﬁned as the level of government purchases that is optimal from a static, cost-beneﬁt standpoint, taking into account that, due to slack resources, shadow costs may be lower during a slump; the latter measures deviations from the former. I show that stimulus spending may be zero throughout, or switch signs, depending on parameters. Finally, I consider the hybrid where monetary policy is discretionary, but ﬁscal policy has commitment. In this case, stimulus spending is typically positive and increasing throughout the trap.
If I were a policymaker, I’d be trying to take a meta-rational stance relative to these various lines of research using New Keynesian models. What I think they show, taken as a whole, is that the details of proper fiscal policy are highly sensitive to different kinds of modeling assumptions. So I’d want to try to make my fiscal efforts geared to things that have some positive benefit outside the scope of the model. Tax cuts or transfers targeted at the objectively needy, try to avoid cuts in useful state/local public services. The monetary conclusions about the importance of expectations, commitment, and credibility are much clearer and seem to pop up in everyone’s models so I think it’s really important for policymakers to be firm about this stuff. We tend, instead, to get weasel words from central bankers or strident efforts to reassure the public about long-term inflation which is counterproductive.