Monetary and fiscal policy in a liquidity trap with inflation persistence

Abstract

This paper relies on the new Keynesian model with structural inflation persistence to characterize the optimal monetary and fiscal policy in a liquidity trap. It shows that, with a Phillips curve that is both forward and backward looking, the monetary policy that is implemented during a liquidity trap episode can be sufficient to avoid a depression. The central bank does not need to commit beyond the end of the crisis to get some traction on economic activity. Regarding fiscal policy, inflation persistence justifies some front-loading of government expenditures to get inflation started, such as to reduce the real interest rate. The magnitude of the optimal fiscal stimulus is decreasing in the degree of inflation persistence. Finally, if inflation persistence is due to adaptive expectations, rather than to price indexation, then monetary policy is ineffective while the optimal fiscal stimulus is large and heavily front-loaded.