Fiscal and monetary policy interaction at the effective lower bound

Largely over the past decade or so, there has been a substantial decline in estimates of global and domestic neutral interest rates, that is, the interest rate that on average, over time, would be consistent with price stability and maximum sustainable employment. Lower neutral rates have limited the extent of conventional policy rate cuts that central banks can deliver when faced with weaker economic conditions. To overcome the constraint of the effective lower bound on interest rates, central banks have adopted new tools and governments have drawn upon their fiscal resources. These novel responses and their interactions are at the centre of policy debates on macroeconomic stabilisation policies. A key lesson from the research is that fiscal stimulus can be an effective means to mitigate falls in output and incomes and it can help monetary policy meet its price stability and employment objectives. The effectiveness of fiscal stimulus at the ELB depends on the details of the stimulus, including the types of spending or taxes that change, the duration of the change and the duration of the ELB episode, expectations of future fiscal policy and the expected monetary policy response to rising inflation. The most effective forms of fiscal stimulus contribute directly to demand for labour and capital, such as spending on health and infrastructure, but there may be practical limits on how much can be achieved in the short run. In practice, the most effective forms of short-term fiscal stimulus tend to be those that are focused on supporting lower income households, which typically have a higher propensity to spend. Government stimulus spending is most effective when private demand is weak. When normal monetary policy resumes, continued stimulus may crowd out private demand, reducing its effectiveness.