Optimal Monetary and Fiscal Policy at the Zero Lower Bound in a Small Open Economy∗

We study optimal monetary and fiscal policy at the zero lower bound in a small open economy model with sticky prices and a flexible exchange rate. In such a liquidity trap situation, the economy suffers from a negative output gap, producer price deflation, and an appreciated real exchange rate (compared to its efficient level). The extent of these adverse effects and the duration of the liquidity trap is higher, lower is the elasticity of substitution between domestic and foreign goods. Under discretion, compared to commitment, in addition to the usual “deflation bias” present in a closed economy, the equilibrium in a small open economy also features an “overvaluation bias”: the real exchange rate is excessively appreciated compared to its efficient level. Countercyclical fiscal policy, that is, increasing government spending above the efficient level during the liquidity trap, constitutes optimal policy and helps decrease the extent of negative output gap and deflation, especially under discretion, but the extent of the increase in government spending is lower when the elasticity of substitution of between domestic and foreign goods is higher. JEL Classification: E31, E52, E58; E61; E62; E63; F41