Monetary-Fiscal Policy Interactions and Uncertain Effective Lower Bound

This paper revisits monetary-fiscal policy interactions when the policymaker has Knightian uncertainty about the exact position of the effective lower bound (ELB). We characterize optimal discretionary policy when a benevolent policymaker controls the nominal interest rate and the level of government spending. Compared to the full information case, an uncertainty-averse policymaker overestimates the level of the ELB, thereby triggering a more aggressive reduction in the nominal interest rate prior to the liquidity trap. The anticipation of a larger increase in public spending improves the trade-off between inflation and output, and dampens the perceived worst-case level of ELB. In addition, we show that a forward guidance regime (alone or coupled with a countercyclical fiscal rule) is more effective than public consumption in responding to the liquidity trap