Fiscal And Monetary Policy Interactions In A Liquidity Trap When Government Debt Matters

What does central bank independence imply for the optimal conduct of time-consistent fiscal and monetary policy in a liquidity trap? To provide an answer, I consider a stochastic noncooperative game in which the lower bound on nominal rates is an occasionally binding constraint and in which government debt serves as a tool to influence future policy trade-offs. I show that a transitory consolidation of debt in the liquidity trap optimally reduces expected real rates and stimulates current consumption and inflation via an expectation channel. The reaction function of the independent central bank outside the lower bound is pivotal in obtaining this result - considering instead coordinated policy produces the opposite effect of an optimal increase in debt. Lengthening the debt maturity allows to mitigate issues related to lack of coordination