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Fiscal Policy in an Expectations Driven Liquidity Trap

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  • Mertens, Karel
  • Ravn, Morten O.

Abstract

We examine the impact of fiscal policy interventions in an environment where the short term nominal interest rate is at the zero bound. In the basic New Keynesian model in which the monetary authority operates a Taylor rule, globally multiple equilibria arise, some of which display all the features of a liquidity trap. A loss in confidence can set the economy on a deflationary path that eventually prevents the monetary authority from adjusting the interest rate and can lead to potentially very large output drops. Contrary to a line of recent papers, we find that demand stimulating policies become less effective in a liquidity trap than in normal circumstances. The key reason is that demand stimulus leads agents to believe that things are even worse than they thought. In contrast, supply side policies, such as cuts in labor income taxes, lead to relative optimism and become more powerful.

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Bibliographic Info

Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 7931.

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Date of creation: Jul 2010
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Handle: RePEc:cpr:ceprdp:7931

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Related research

Keywords: confidence shocks; fiscal policy; liquidity trap; sunspots;

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  1. Cogan, John F. & Cwik, Tobias & Taylor, John B. & Wieland, Volker, 2010. "New Keynesian versus old Keynesian government spending multipliers," Journal of Economic Dynamics and Control, Elsevier, vol. 34(3), pages 281-295, March.
  2. Miguel Almunia & Agustín S. Bénétrix & Barry Eichengreen & Kevin H. O'Rourke & Gisela Rua, 2009. "From Great Depression to Great Credit Crisis: Similarities, Differences and Lessons," NBER Working Papers 15524, National Bureau of Economic Research, Inc.
  3. Giovanni Dell'Ariccia & Olivier J. Blanchard & Paolo Mauro, 2010. "Rethinking Macroeconomic Policy," IMF Staff Position Notes 2010/03, International Monetary Fund.
  4. Evans, G.W. & Guse, E. & Honkapohja, S, 2007. "Liquidity Traps, Learning and Stagnation," Cambridge Working Papers in Economics 0732, Faculty of Economics, University of Cambridge.
  5. Emi Nakamura & Jón Steinsson, 2008. "Five Facts about Prices: A Reevaluation of Menu Cost Models," The Quarterly Journal of Economics, MIT Press, vol. 123(4), pages 1415-1464, November.
  6. Olivier Coibion & Yuriy Gorodnichenko, 2011. "Monetary Policy, Trend Inflation, and the Great Moderation: An Alternative Interpretation," American Economic Review, American Economic Association, vol. 101(1), pages 341-70, February.
  7. Christopher J. Erceg & Jesper Linde, 2010. "Is there a fiscal free lunch in a liquidity trap?," International Finance Discussion Papers 1003, Board of Governors of the Federal Reserve System (U.S.).
  8. Benhabib, Jess & Farmer, Roger E.A., 1999. "Indeterminacy and sunspots in macroeconomics," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 6, pages 387-448 Elsevier.
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  1. ZLB Models?
    by Mainly Macro in Mainly Macro on 2013-08-01 12:06:00
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