Time‐Consistent Management of a Liquidity Trap with Government Debt

Abstract: I show that debt maturity considerations affect the optimal conduct of monetary and fiscal policy in the presence of lower bound episodes. I consider a New Keynesian model where the lower bound on nominal interest rates binds occasionally. I study optimal monetary and fiscal policy under discretion, characterizing the strategic use of government debt as a tool to affect expectations of real interest rates and inflation. During lower bound episodes, the presence of long‐term bonds makes it optimal to temporarily consolidate debt. In addition, the long‐run level of debt increases with both the likelihood of reaching the lower bound and the maturity of debt.