Gauti B. Eggertsson

The Zero Bound on Interest Rates and Optimal Monetary Policy

This paper considers the consequences for monetary policy of the zero floor for nominal interest rates. The zero bound can be a significant constraint on the ability of a central bank to combat deflation. The paper shows, in the context of an intertemporal equilibrium model, that open-market operations, even of unconventional types, are ineffective if future policy is expected to be purely forward looking. However, a credible commitment to the right sort of history-dependent policy can largely mitigate the distortions created by the zero bound. In the model, optimal policy involves a commitment to adjust interest rates so as to achieve a time-varying price-level target, when this is consistent with the zero bound. The paper also discusses ways in which other central bank actions, although irrelevant apart from their effects on expectations, may help to make a central banks commitment to its target more credible.

What Fiscal Policy is Effective at Zero Interest Rates

Tax cuts can deepen a recession if the short-term nominal interest rate is zero, according to a standard New Keynesian business cycle model. An example of a contractionary tax cut is a reduction in taxes on wages. This tax cut deepens a recession because it increases deflationary pressures. Another example is a cut in capital taxes. This tax cut deepens a recession because it encourages people to save instead of spend at a time when more spending is needed. Fiscal policies aimed directly at stimulating aggregate demand work better. These policies include 1) a temporary increase in government spending; and 2) tax cuts aimed directly at stimulating aggregate demand rather than aggregate supply, such as an investment tax credit or a cut in sales taxes. The results are specific to an environment in which the interest rate is close to zero, as observed in large parts of the world today.

Can Structural Reforms Help Europe

Structural reforms that increase competition in product and labor markets are often indicated as the main policy option available for peripheral Europe to regain competitiveness and boost output. We show that, in a crisis that pushes the nominal interest rate to its lower bound, these reforms do not support economic activity in the short run, and may well be contractionary. In the absence of the appropriate monetary stimulus, reforms fuel expectations of prolonged deflation, increase the real interest rate, and depress aggregate demand. Our findings carry important implications for the current debate on the timing and the design of structural reforms in Europe.

Was the New Deal Contractionary

Can government policies that increase the monopoly power of firms and the militancy of unions increase output? This paper studies this question in a dynamic general equilibrium model with nominal frictions and shows that these policies are expansionary when certain “emergency” conditions apply. I argue that these emergency conditions— zero interest rates and deflation—were satisfied during the Great Depression in the United States. Therefore, the New Deal, which facilitated monopolies and union militancy, was expansionary, according to the model. This conclusion is contrary to the one reached by Cole and Ohanian (2004), who argue that the New Deal was contractionary. The main reason for this divergence is that the current model incorporates nominal frictions so that inflation expectations play a central role in the analysis. The New Deal has a strong effect on inflation expectations in the model,changing excessive deflation to modest inflation, thereby lowering real interest rates and stimulating spending.

Policy Options in a Liquidity Trap

The specter of a “liquidity trap,” originally proposed as a theoretical possibility by John Maynard Keynes (1936) but long considered to be of doubtful practical relevance, has recently created alarm among the world’s central banks. In Japan, the overnight rate has been essentially at zero for most of the time since February 1999, making further interest-rate cuts impossible. Yet until well into 2003, growth remained anemic while prices continued to fall, suggesting a need for further monetary stimulus. Since March 2001, the Bank of Japan has supplemented its “zero-interest-rate policy” with a policy of “quantitative easing,” under which additional bank reserves are supplied beyond those needed to keep overnight interest rates at zero. Yet an increase in base money of more than 50 percent failed to halt the deflation, suggesting a liquidity trap. More recently, other central banks, including the Fed, have come close enough to the zero bound to worry about how they would deal with a similar predicament. Here we first discuss whether monetary policy should actually become ineffective when the zero bound on interest rates is reached. We argue that open-market operations, even of “unconventional” types, will be ineffective if they do not change expectations about the future conduct of policy; in this sense, a liquidity trap is possible. Nonetheless, a credible commitment regarding future policy can largely mitigate the distortions created by the zero bound. We fully characterize the optimal commitment in a simple example.

The Paradox of Toil

This paper proposes a new paradox: the paradox of toil. Suppose everyone wakes up one day and decides they want to work more. What happens to aggregate employment? This paper shows that, under certain conditions, aggregate employment falls; that is, there is less work in the aggregate because everyone wants to work more. The conditions for the paradox to apply are that the short-term nominal interest rate is zero and there are deflationary pressures and output contraction, much as during the Great Depression in the United States and, perhaps, the 2008 financial crisis in large parts of the world. The paradox of toil is tightly connected to the Keynesian idea of the paradox of thrift. Both are examples of a fallacy of composition.

How to Fight Deflation in a Liquidity Trap; Committing to Being Irresponsible

I model deflation, at zero nominal interest rate, in a microfounded general equilibrium model. I show that deflation can be analyzed as a credibility problem if the government has only one policy instrument, money supply carried out by means of open market operations in short-term bonds, and cannot commit to future policies. I propose several policies to solve the credibility problem. They involve printing money or nominal debt and either (1) cutting taxes, (2) buying real assets such as stocks, or (3) purchasing foreign exchange. The government credibly commits to being irresponsible by using these policy instruments. It commits to higher money supply in the future so that the private sector expects inflation instead of deflation. This is optimal, since it curbs deflation and increases output by lowering the real rate of return.

Deficits, Public Debt Dynamics and Tax and Spending Multipliers

Cutting government spending on goods and services increases the budget deficit if the nominal interest rate is close to zero. This is the message of a simple but standard New Keynesian DSGE model calibrated with Bayesian methods. The cut in spending reduces output and thus — holding rates for labor and sales taxes constant — reduces revenues by even more than what is saved by the spending cut. Similarly, increasing sales taxes can increase the budget deficit rather than reduce it. Both results suggest limitations of “austerity measures” in low interest rate economies to cut budget deficits. Running budget deficits can by itself be either expansionary or contractionary for output, depending on how deficits interact with expectations about the long run in the model. If deficits trigger expectations of i) lower long-run government spending, ii) higher long-run sales taxes, or iii) higher future inflation, they are expansionary. If deficits trigger expectations of higher long-run labor taxes or lower long-run productivity, they are contractionary.

Fiscal Multipliers and Policy Coordination

This paper addresses the effectiveness of fiscal policy at zero nominal interest rates. I analyze a stochastic general equilibrium model with sticky prices and rational expectations and assume that the government cannot commit to future policy. Real government spending increases demand by increasing public consumption. Deficit spending increases demand by generating inflation expectations. I derive fiscal spending multipliers that calculate how much output increases for each dollar of government spending (real or deficit). Under monetary and fiscal policy coordination, the real spending multiplier is 3.4 and the deficit spending multiplier is 3.8. However, when there is no policy coordination, that is, when the central bank is goal independent, the real spending multiplier is unchanged but the deficit spending multiplier is zero. Coordination failure may explain why fiscal policy in Japan has been relatively less effective in recent years than during the Great Depression.

Is increased price flexibility stabilizing? Redux

We study the implications of increased price flexibility on output volatility. In a simple DSGE model, we show analytically that more flexible prices always amplify output volatility for supply shocks and also amplify output volatility for demand shocks if monetary policy does not respond strongly to inflation. More flexible prices often reduce welfare, even under optimal monetary policy if full efficiency cannot be attained. We estimate a medium-scale DSGE model using post-WWII U.S. data. In a counterfactual experiment we find that if prices and wages are fully flexible, the standard deviation of annualized output growth more than doubles.