Alice through the Looking Glass: Strategic Monetary and Fiscal Policy Interaction in a Liquidity Trap

University of Leicester, Department of Economics Working Paper No. 07/15

44 Pages Posted: 12 May 2008

See all articles by Sanjit Dhami

Sanjit Dhami

University of Leicester

Ali al-Nowaihi

University of Leicester - Department of Economics

Date Written: October 30, 2007

Abstract

The recent experience with low inflation has reopened interest in the liquidity trap; which occurs when the nominal interest rate reaches its zero lower bound. To reduce the real interest rate, and to stimulate the economy, the modern literature highlights the role of high inflationary expectations. Using the Dixit-Lambertini (2003) framework of strategic policy interaction, we find that the optimal institutional response to the possibility of a liquidity trap has two main components. First, an optimal inflation target given to the Central Bank. Second, the Treasury, who retains control over fiscal policy and acts as leader, is given optimal output and inflation targets. This keeps inflationary expectations sufficiently high and achieves the optimal rational expectations pre-commitment solution. Simulations show that this arrangement is (1) optimal even when the Treasury has no inflation target but follows the optimal output target and (2) near optimal even when the Treasury follows its own agenda through a suboptimal output target but is willing to follow an optimal inflation target. Finally, if monetary policy is delegated to an independent central bank with an optimal inflation target, but the Treasury retains discretion over fiscal policy, then the outcome can be a very poor one.

Keywords: liquidity trap, strategic monetary-fiscal interaction, optimal Taylor rules

JEL Classification: E63, E52, E58, E61

Suggested Citation

Dhami, Sanjit and al-Nowaihi, Ali, Alice through the Looking Glass: Strategic Monetary and Fiscal Policy Interaction in a Liquidity Trap (October 30, 2007). University of Leicester, Department of Economics Working Paper No. 07/15, Available at SSRN: https://ssrn.com/abstract=1130795 or http://dx.doi.org/10.2139/ssrn.1130795

Sanjit Dhami (Contact Author)

University of Leicester ( email )

Department of Economics
Leicester LE1 7RH, Leicestershire LE1 7RH
United Kingdom

HOME PAGE: http://www2.le.ac.uk/departments/economics/people/sdhami

Ali Al-Nowaihi

University of Leicester - Department of Economics ( email )

Department of Economics
Leicester LE1 7RH, Leicestershire LE1 7RH
United Kingdom

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