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Optimal institutional design when there is a zero lower bound on interest rates

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journal contribution
posted on 2011-10-10, 15:14 authored by Sanjit Dhami, Ali al-Nowaihi
Given the recent experience, there is a growing interest in the liquidity trap, which occurs when the nominal interest rate reaches its zero lower bound. We outline the surprising policy recommendations when there is the possibility of a zero lower bound. Then, using the Dixit-Lambertini framework of strategic policy interaction between the Treasury and the Central Bank, we find that the optimal institutional response to the possibility of a liquidity trap has two main components. First, an optimal inflation target is given to the Central Bank. Second, the Treasury, which retains control over fiscal policy and acts as Stackelberg leader, is given optimal output and inflation targets. This institutional solution achieves the optimal rational expectations pre-commitment solution.

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Citation

Oxford Economic Papers, 2011, 63 (4), pp. 700-721.

Version

  • AM (Accepted Manuscript)

Published in

Oxford Economic Papers

Publisher

Oxford University Press (OUP)

issn

0030-7653

eissn

1464-3812

Copyright date

2011

Available date

2011-10-10

Publisher version

http://oep.oxfordjournals.org/content/63/4/700

Language

en

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