Strategic monetary and fiscal policy interaction in a liquidity trap

In its classical form, the liquidity trap, a term coined by Keynes (1936), is a situation where an increase in money supply fails to reduce the nominal interest rate. The modern literature has concentrated on the case where the nominal interest rate has been driven down to zero (the so called ‘zero bound’). The source of a liquidity trap, in most circumstances, is a sharp fall in aggregate demand; see Keynes (1936), Bernanke (2002). Interest in the liquidity trap has revived in recent years due, in no small measure, to the experience of Japan since 1990. Woodford (2005, 29) discusses the near miss of the US economy from a liquidity trap in the summer of 2003. The era of successful delegation of monetary policy to independent central banks with low inflation targets1 opens up the possibility that sufficiently large negative demand shocks might push an economy into a liquidity trap with huge associated welfare consequences.2 Blanchard et al. (2010) propose an inflation target of 4 percent in order to provide greater range for the nominal interest rate instrument. Our paper provides one framework within which to evaluate this proposal.