Fiscal and Monetary Stabilization Policy at the Zero Lower Bound: Consequences of Limited Foresight

We consider the effectiveness of stabilization policy when the zero lower bound (ZLB) is a relevant constraint on conventional monetary policy by relaxing the assumption of rational expectations. In particular, we assume bounded rationality in terms of limited foresight—people can plan for only a finite distance into the future when they deductively reason about the economy's future evolution. We examine how the degree of foresight affects the outcomes of fiscal and monetary stabilization policy.

We find that when planning horizons are finite, the contractionary effects of a financial disturbance are not as significant as they are in a rational-expectations analysis. But, as long as there is some degree of foresight, even a relatively modest financial wedge can substantially impact stabilization goals if additional policy tools for exceptional circumstances are not available.

Given that Ricardian equivalence does not hold with finite planning horizons, we reconsider countercyclical fiscal transfers as a potential stabilization tool. We show that fiscal transfers can be powerful in reducing the contractionary impact of a financial disturbance, and can even completely stabilize both aggregate output and inflation despite a binding ZLB constraint. But the effectiveness of fiscal transfers relies on their degree of monetary accommodation. We also show that a higher level of welfare is generally possible if both monetary and fiscal authorities commit to history-dependent policies after the financial disturbance has dissipated.