Fiscal Deficits, Debt, and Monetary Policy in a Liquidity Trap - Dallas Fed

The macroeconomic response to the economic crisis has revived old debates about the usefulness of monetary and fiscal policy in fighting recessions. Without the ability to further lower interest rates, policy authorities in many countries have turned to expansionary fiscal policies. Recent literature argues that government spending may be very effective in such environments. But a critical element of the stimulus packages in all countries was the use of deficit financing and tax reductions. This paper explores the role of government debt and deficits in an economy constrained by the zero bound on nominal interest rates. Given that the liquidity trap is generated by a large increase in the desire to save on the part of the private sector, the wealth effects of government deficits can provide a critical macroeconomic response to this. Government spending .financed by deficits may be far more expansionary than that financed by tax increases in such an environment. In a liquidity trap, tax cuts may be much more effective than during normal times. Finally, monetary policies aimed at directly increasing monetary aggregates may be effective, even if interest rates are unchanged. JEL codes: E2, E5, E6 * Michael B. Devereux, Department of Economics, University of British Columbia, 997-1873 East Mall, Vancouver, B.C. Canada V6T 1Z. 604-822-2542. [email protected]. This paper was prepared for the Central Bank of Chile Thirteenth Annual Conference, “Monetary Policy under Financial Turbulence,” November 19-20, 2009. I thank my discussant, Philip Lane, as well participants at the conference, for comments. I thank Changhua Yu and Na Zhang for research assistance. I thank SSHRC, the Bank of Canada, and the Royal Bank of Canada for financial support. The views in this paper are those of the author and do not necessarily reflect the views of the Federal Reserve Bank of Dallas or the Federal Reserve System.