Ebook International Monetary and Fiscal Policy Coordination in a Liquidity Trap
The dramatic macroeconomic policy responses to the 2008-2009 global economic crisis has revived interest in the use of counter cyclical fiscal and monetary policy. The central dilemma for policy makers in responding to the rapid global downturn was to counter a recession precipitated by an unprecented fall in private consumption and investment spending, but at the same time having little ability to reduce nominal interest rates below their record low levels. Policy makers followed ad hoc series of fiscal and monetary measures government spending increases, tax cuts, and 'unconventional' monetary policy measures such as open market purchases on long dated securities, direct increases in the monetary base, etc. In general, these policies were not obtained from the standard DSGE theoretical frameworks, but rather produced from 'back of the envelope' style arguments about the size of fiscal multipliers and the impact of liquidity injections on credit flows.
Interestingly, the issue of designing appropriate fiscal and monetary policy responses in face of a zero lower bound on nominal interest rates had been extensively debated earlier in the decade, in light of the 1990's experience of Japan. In particular, Krugman (1999), Eggertson and Woodford (2003, 2005), Jung et al. (2005), Svensson, Auerbach and Obstfeld (2004) and many other writers explored how monetary and fiscal policy could be usefully employed even when the authorities have no further room to reduce short term nominal interest rates. Recently, a number of authors have revived this literature in light of the very similar problems now encountered by the economies of Western Europe and North America. Papers by Christiano et al (2009), Eggertson (2009), Taylor et al. (2008) have explored the possibility for using government spending expansions, tax cuts, and monetary policy when the economy is in a 'liquidity trap'.
One key new aspect of the dilemma faced by authorities in the recent policy environment was that the liquidity trap was a global phenomenon. In most previous literature, analysis of the zero bound constraint on nominal interest rates focused on the problems facing either a closed economy, or a small open economy in which policy makers in the rest of the world were not faced with the analogous constraints. But when most major countries are facing similar constraints on monetary policy, it is not clear how easy or useful it is to follow the conclusions of the previous literature. First, there is a question of examining how a shock which pushes an economy beyond the zero lower bound in nominal interest rates is spread across countries. How are liquidity traps 'propagated' across countries? Secondly, policies which help to alleviate a liquidity trap in one country may exacerbate the problems in neighboring countries. The external dimension may substantially alter the effects of a given set of policy responses within a liquidity trap. Furthermore, there may be considerable benefit to coordination of policies across countries, and optimally coordinated policies may differ from the rules that would be extrapolated from the analysis of closed economies or small open economies.
This paper examines the joint determination of monetary and fiscal policies in a two country world economy where one or both countries are suspectible to negative demand shocks that precipitate a liquidity trap. The paper explores three questions relevant to the previous discussion. First, we ask how a liquidity trap is propagated across countries. In particular, taking a negative demand shock in one country which would push the unconstrained optimal nominal interest rate below zero, we ask how this is likely to impact on the policy problem in the neighboring country. Secondly, we examine the use of counter cyclical fiscal policy within a liquidity trap. Recent literature has argued that fiscal policy becomes very effective when the monetary authority has no ability to adjust interest rates. We explore how this argument holds up in a global framework with separate fiscal responses, in an environment where either one or both countries is in a liquidity trap. As an additional question, we ask how the the monetary policy followed by an unconstrained country affects the response to fiscal policy in a liquidity trap. Finally, we explore the jointly optimal monetary and fiscal policy problem in an environment where fiscal and monetary authorities maximize an approximated world social welfare function. With this framework we can ask how useful is fiscal policy in responding to a liquidity trap, and how much of a contribution is made by international coordination of policy. A key distinction here is whether policy makers can commit to future policy. If the monetary authority cannot commit to expansionary monetary policy after exiting the liquidity trap, then fiscal policy is effectively the only tool that can be used in response to a liquidity trap. In essence, the paper is an attempt to extend the recent literature on policy making under the zero lower bound to a global environment, where both fiscal and monetary policy are jointly determined.
The basic modeling environment we use is quite standard in the recent open economy literature. In particular, our model is essentially a convex combination of the models of Beetsma and Jensen (2005), who incorporated government spending into a two country open economy environment, and Engel (2010), who looked at an optimal policy environment with home bias in consumer preferences2. In both cases, the assumption is that there is a complete set of markets for consumption insurance across countries. We focus on the role of demand shocks in these models, and crucially, add the zero bound as an additional constraint on monetary policy determination.
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