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Liquidity Traps and Expectation Dynamics: Fiscal Stimulus or Fiscal Austerity?

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  • Benhabib, Jess
  • Evans, George W.
  • Honkapohja, Seppo

Abstract

We examine global dynamics under infinite-horizon learning in New Keynesian models where the interest-rate rule is subject to the zero lower bound. As in Evans, Guse and Honkapohja (2008), the intended steady state is locally but not globally stable. Unstable deflationary paths emerge after large pessimistic shocks to expectations. For large expectation shocks that push interest rates to the zero bound, a temporary fiscal stimulus or a policy of fiscal austerity, appropriately tailored in magnitude and duration, will insulate the economy from deflation traps. However "fiscal switching rules" that automatically kick in without discretionary fine tuning can be equally effective.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 9176.

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Date of creation: Oct 2012
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Handle: RePEc:cpr:ceprdp:9176

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Keywords: adaptive learning; fiscal policy; monetary policy; zero interest rate lower bound;

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  1. Fabio Milani, 2005. "Expectations, Learning and Macroeconomic Persistence," Working Papers 050608, University of California-Irvine, Department of Economics.
  2. Rotemberg, Julio J, 1982. "Sticky Prices in the United States," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 90(6), pages 1187-1211, December.
  3. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 1998. "The perils of Taylor Rules," Departmental Working Papers, Rutgers University, Department of Economics 199831, Rutgers University, Department of Economics.
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  1. Is it time for the Fed to raise its policy rate?
    by David Andolfatto in MacroMania on 2013-01-20 02:18:00
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Cited by:
  1. Michael Woodford, 2013. "Macroeconomic Analysis without the Rational Expectations Hypothesis," NBER Working Papers 19368, National Bureau of Economic Research, Inc.

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