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Policy Interaction, Expectation and Liquidity Trap

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  • Evans, George W
  • Honkapohja, Seppo

Abstract

We consider inflation and government debt dynamics when monetary policy employs a global interest rate rule and private agents forecast using adaptive learning. Because of the zero lower bound on interest rates, active interest rate rules are known to imply the existence of a second, low inflation steady state, below the target inflation rate. Under adaptive learning dynamics we find the additional possibility of a liquidity trap, in which the economy slips below this low inflation steady state and is driven to an even lower inflation floor that is supported by a switch to an aggressive money supply rule. Fiscal policy alone cannot push the economy out of the liquidity trap. Raising the threshold at which the money supply rule is employed can, however, dislodge the economy from the liquidity trap and ensure a return to the target equilibrium.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 3925.

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Date of creation: Jun 2003
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Handle: RePEc:cpr:ceprdp:3925

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Keywords: deflation; economic policy; learning;

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  1. Evans, George W & Honkapohja, Seppo, 1995. "Local Convergence of Recursive Learning to Steady States and Cycles in Stochastic Nonlinear Models," Econometrica, Econometric Society, vol. 63(1), pages 195-206, January.
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Cited by:
  1. James Bullard & In-Koo Cho, 2003. "Escapist policy rules," Working Papers 2002-002, Federal Reserve Bank of St. Louis.
  2. Alstadheim Ragna & Henderson Dale W., 2006. "Price-Level Determinacy, Lower Bounds on the Nominal Interest Rate, and Liquidity Traps," The B.E. Journal of Macroeconomics, De Gruyter, vol. 6(1), pages 1-27, November.
  3. Roberto M. Billi & Klaus Adam, 2004. "Optimal Monetary Policy under Commitment with a Zero Bound on Nominal Interest Rates," Computing in Economics and Finance 2004 67, Society for Computational Economics.

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