Optimal Institutional Design when there is a Zero Lower Bound on Interest Rates

Given the recent experience, there is a growing interest in the liquidity trap; which occurs when the nominal interest rate reaches its zero lower bound. We out-line the surprising policy recommendations when there is the possibility of a zero lower bound. Then, using the Dixit-Lambertini (2003) framework of strategic policy interaction between the Treasury and the Central Bank, we \u85nd that the optimal institutional response to the possibility of a liquidity trap has two main components. First, an optimal ination target is given to the Central Bank. Second, the Treasury, who retains control over \u85scal policy and acts as Stackelberg leader, is given optimal output and ination targets. This institutional solution achieves the optimal rational expectations pre-commitment solution