How should monetary and fiscal policy react to adverse financial shocks? If monetary policy is constrained by the zero lower bound on the nominal interest rate, subsidising the interest rate on loans is the optimal policy. The subsidies can mimic movements in the interest rate and can therefore...

In a model with costly financial intermediation and financial disturbances, credit subsidies are desirable, irrespective of how they are financed. They are especially useful when the zero lower bound constraint is reached. They are superior to other credit policies such as direct lending.

Nominal interest rates typically approach the zero-lower bound during a financial crisis. This is a constraint on optimal monetary policy: In a model with financial frictions, policy would set negative nominal interest rates in response to increases in credit spreads. We find that fiscal policy...