Committing to being Irresponsible: DeÞcit Spending to Escape a Liquidity Trap

This paper explores the peculiar credibility problem that a zero bound on the short-term nominal interest rate, the liquidity trap, poses to monetary and Þscal policy. We present a rational expectations model in which the zero bound on short-term nominal interest rates is binding due to deßationary shocks. When the zero bound is binding the Central Bank best achieves its objectives by generating inßation expectations to lower the real rate of interest and stimulate aggregate demand. A discretionary Central Bank that is independent from Þscal policy, however, cannot credibly commit to inßation. The result is a liquidity trap that is characterized by excessive deßation and a negative output gap. This deßation bias is the opposite of the inßation bias analyzed by Barro/Gordon (1983) and Kydland/Prescott (1977). Turning to Þscal policy, our model implies that if the Central Bank is independent then Ricardian equivalence holds and deÞcit spending, i.e. tax cuts and debt accumulation, has no effect. Our proposed solution involves abolishing the independence of the Central Bank. If Þscal and monetary policies are coordinated, Ricardian Equivalence fails, and the government can credibly commit to future inßation by deÞcit spending. As a result it lowers the real rate of return, curbs deßation and increases output. Finally we address what coordination of Þscal and monetary policy might entail in practice. We review the applicability of our model to the current situation in Japan. We then discuss the extent to which the successful policies pursued in Japan during the Great Depression can be rationalized by our model. * Princeton University. It is impossible to overstate the debt I owe to Michael Woodford for continu-ous advise, support and extensive comments on various versions of this paper. Im also indebted to Ben Bernanke, Paul Krugman, Robert Shimer and Christopher Sims for several helpful comments and discus-sions in the process of writing this paper. Finally I would like to thank Alan Blinder, Helima Croft, Apraji