Policy at the Zero Bound

When nominal interest rates are at the zero bound, so that monetary policy cannot be used to provide appropriate stymulus, tax policy can accomplish that at zero cost. There is no need to use ine¢ cient policies, such as wasteful public spending. This means that the zero bound on nominal interest rates is not a relevant constraint on both …scal and monetary policy. Key words : Zero Bound; Fiscal policy; Monetary policy; Sticky prices. JEL classi…cation : E31; E40; E52; E58; E62; E63. 1 Introduction Arbitrage between money and bonds restricts nominal interest rates from becoming negative. One could imagine circumstances in which, in the event of a potential recession, it is desirable for the Central Bank to lower the policy rate. If the interest rate is very close to zero to begin with, the constraint may be binding. This is the "zero bound" problem of monetary policy. But, is there a zero bound problem when policy is more generally considered to include both …scal and monetary instruments? Is …scal policy able to avoid a downturn when the zero bound constraint binds? In this paper we show that We thank Fernando Alvarez, Patrick Kehoe, Javier Garcia-Cicco, Narayana Kocherlakota, Kjetil Storesletten, Sam Schulhofer-Wohl, Tao Zha, as well as participants at seminars at the Bank of Spain, the Federal Reserve Banks of Atlanta, Chicago, Minneapolis and St Louis. Correia and Teles gratefully acknowledge …nancial support of FCT.