Jean-Baptiste Michau (Ecole Polytechnique) – Secular Stagnation: Theory and Remedies

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This paper relies on a Ramsey model with money to offer a simple theory of secular stagnation. The permanent failure of the economy to produce at full capacity results from three features: 1. The combination of the zero lower bound on the nominal interest rate and of an inflation ceiling imposes a lower bound on the real interest rate; 2. Some dynastic households have a high propensity to save, due to a preference for wealth; 3. A downward wage rigidity breaks the deflationary spiral resulting from the lack of demand. In this framework, I derive the paradox of flexibility, of thrift, and of toil. If the inflation ceiling cannot be raised, then the government needs to rely on fiscal policy to escape secular stagnation. However, a conventional fiscal stimulus is not an efficient response to a permanent liquidity trap, and can even be welfare reducing. The solution is instead to tax household wealth and to subsidize income from physical capital, through an investment subsidy or a reduction in the taxation of corporate income. This optimal policy is revenue neutral and implements the first-best allocation of resources. However, to avoid a jump in the price level upon implementation of the optimal policy, the government needs to redeem the money that had previously been supplied to finance public debits.

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