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The New-Keynesian Liquidity Trap

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  • John H. Cochrane

Abstract

In standard solutions, the new-Keynesian model produces a deep recession with deflation in a liquidity trap. Useless government spending, technical regress, and capital destruction have large positive multipliers. The recession prediction, and deflation and policy paradoxes are larger when prices are less sticky. I show that these puzzling predictions are artifacts of equilibrium selection. For the same interest-rate policy, different choices of multiple equilibria overturn all these results. A "local-to-frictionless" equilibrium, for the same interest rate policy, predicts mild inflation, no output reduction and negative multipliers during the liquidity trap, and its predictions approach the frictionless model smoothly.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 19476.

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Date of creation: Sep 2013
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Handle: RePEc:nbr:nberwo:19476

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  1. Bennett McCallum, . "Multiple-Solution Indeterminacies in Monetary Policy Analysis," GSIA Working Papers 2003-E77, Carnegie Mellon University, Tepper School of Business.
  2. Obstfeld, Maurice & Rogoff, Kenneth, 1983. "Speculative Hyperinflations in Maximizing Models: Can We Rule Them Out?," Journal of Political Economy, University of Chicago Press, vol. 91(4), pages 675-87, August.
  3. Lawrence Christiano & Martin Eichenbaum & Sergio Rebelo, 2009. "When is the government spending multiplier large?," NBER Working Papers 15394, National Bureau of Economic Research, Inc.
  4. John H. Cochrane, 2007. "Determinacy and Identification with Taylor Rules," NBER Working Papers 13410, National Bureau of Economic Research, Inc.
  5. Olivier Blanchard & Giovanni Dell'Ariccia & Paolo Mauro, 2010. "Rethinking Macroeconomic Policy," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 42(s1), pages 199-215, 09.
  6. R. Anton Braun & Lena Mareen Körber & Yuichiro Waki, 2012. "Some unpleasant properties of log-linearized solutions when the nominal rate is zero," Working Paper 2012-05, Federal Reserve Bank of Atlanta.
  7. Obstfeld, Maurice & Rogoff, Kenneth, 1986. "Ruling out divergent speculative bubbles," Journal of Monetary Economics, Elsevier, vol. 17(3), pages 349-362, May.
  8. Olaf Posch & Juan F. Rubio-Ramírez & Jesús Fernández-Villaverde, 2011. "Solving the new Keynesian model in continuous time," 2011 Meeting Papers 829, Society for Economic Dynamics.
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  1. Fiscal Stimulus: Old Keynesian vs. New Keynesian
    by paragwaknis in Musings of the Sorts on 2013-11-17 16:54:51

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