Optimal Fiscal and Monetary Policy With Occasionally Binding Zero Bound Constraints

Previous studies on fiscal policy at the zero bound have focused on models with perfect foresight. However, the recent economic environment motivating such research is characterized by a high degree of uncertainty. This paper studies optimal government spending and monetary policy when the nominal interest rate is subject to the zero lower bound constraint in a stochastic environment. In the presence of uncertainty, the government chooses to increase its spending when at the zero lower bound by a larger amount. The welfare effect of fiscal policy is nuanced in the stochastic environment if the government cannot commit. While the access to government spending policy increases welfare in the face of a large deflationary shock, it can decrease welfare during normal times as the government reduces the nominal interest rate less aggressively before reaching the zero lower bound. The implications of optimal fiscal policy for the average inflation rate are also discussed.