Monetary and Fiscal Remedies for Deflation

13 Pages Posted: 16 Aug 2010 Last revised: 13 Feb 2022

See all articles by Alan J. Auerbach

Alan J. Auerbach

University of California, Berkeley - Department of Economics; National Bureau of Economic Research (NBER); CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Maurice Obstfeld

University of California, Berkeley; Peterson Institute for International Economics; National Bureau of Economic Research; Centre for Economic Policy Research

Date Written: February 2004

Abstract

Prevalent thinking about liquidity traps suggests that the perfect substitutability of money and bonds at a zero short-term nominal interest rate renders open-market operations ineffective for achieving macroeconomic stabilization goals. In an earlier paper, we showed that this reasoning does not hold, that open-market operations can provide substantial macroeconomic benefits and facilitate the use of powerful fiscal policy tools even in a liquidity trap. In this paper, we consider an alternative approach that has been suggested for use in a liquidity trap, a scheduled increase in consumption tax rates. We find that such a policy could, indeed, increase short-run consumption, but would be less effective at increasing welfare or accelerating a country's exit from a liquidity trap. Though a variant of this tax policy might induce exit from a liquidity trap, the impact of welfare is negative in this case as well. We also argue that this alternative tax-rate-based approach is subject to more severe credibility problems than the monetary policy approach explored in our original paper.

Suggested Citation

Auerbach, Alan Jeffrey and Obstfeld, Maurice, Monetary and Fiscal Remedies for Deflation (February 2004). NBER Working Paper No. w10290, Available at SSRN: https://ssrn.com/abstract=1659089

Alan Jeffrey Auerbach (Contact Author)

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Maurice Obstfeld

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