Optimal robust monetary and fiscal policy under uncertainty on the lower bound

Abstract

This paper studies robust policy when the policymaker has Knightian uncertainty about the exact position of the effective lower bound (ELB). First, 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. Furthermore, the anticipation of a larger increase in public spending improves the trade-off between inflation and the output gap, and dampens the perceived worst-case level of the ELB. As a result, a less conservative fiscal stabilization is desirable to address the uncertainty concerns of the policymaker by partially substituting for the nominal interest rate at the ELB. Moreover, an inflation-conservative policymaker mitigates the impact of uncertainty on equilibrium outcomes even better than a fiscally active policymaker.