Working Paper: NBER ID: w27521
Authors: Michael Woodford; Yinxi Xie
Abstract: This paper reconsiders the degree to which macroeconomic stabilization is possible when the zero lower bound is a relevant constraint on the effectiveness of conventional monetary policy, under an assumption of bounded rationality. In particular, we reconsider the potential role of countercyclical fiscal transfers as a tool of stabilization policy. Because Ricardian Equivalence no longer holds when planning horizons are finite (even when relatively long), we find that fiscal transfers can be a powerful tool to reduce the contractionary impact of an increased financial wedge during a crisis, and can even make possible complete stabilization of both aggregate output and inflation under certain circumstances, despite the binding lower bound on interest rates. However, the power of such policies depends on the degree of monetary policy accommodation. We also show that a higher level of welfare is generally possible if both monetary and fiscal authorities commit themselves to history-dependent policies in the period after the financial disturbance that causes the lower bound to bind has dissipated. Hence forward guidance continues to play an important role in increasing the effectiveness of stabilization policy.
Keywords: fiscal policy; monetary policy; zero lower bound; bounded rationality; economic stabilization
JEL Codes: E52; E63; E7
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Fiscal transfers (H87) | stabilization of output and inflation (E63) |
| Monetary accommodation (E52) | effectiveness of fiscal transfers (H87) |
| Coordination between fiscal and monetary policy (E63) | better economic stability (E60) |
| Fiscal transfers (H87) | central bank signaling of future policy intentions (E52) |