Given the recent experience, there is a growing interest in the liquidity trap, which occurs when the nominal interest rate reaches its zero lower bound. We outline the surprising policy recommendations when there is the possibility of a zero lower bound. Then, using the Dixit-Lambertini framework of strategic policy interaction between the Treasury and the Central Bank, we find that the optimal institutional response to the possibility of a liquidity trap has two main components. First, an optimal inflation target is given to the Central Bank. Second, the Treasury, which retains control over fiscal policy and acts as Stackelberg leader, is given optimal output and inflation targets. This institutional solution achieves the optimal rational expectations pre-commitment solution.
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