Looking Beyond the Trap: Fiscal Legacy and Central Bank Independence*

I model a stochastic non-cooperative game between an independent central bank and a treasury and study optimal time-consistent policy in the context of demand-driven recessions and an occasionally binding zero lower bound constraint. Departing from coordination leads to contractionary fiscal policy in the liquidity trap. The persistent decline in short-term government debt improves price stability and welfare albeit at the expense of a deeper recession in the near term. Underlying this policy is the anticipated risk of monetary tightening during the economic recovery in response to fiscally induced inflation. The issuance of long-term government debt helps to buffer the yield to maturity against interest rate fluctuations, thereby reducing the relevance of central bank independence for macroeconomic outcomes.