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. However, raising the threshold at which the money supply rule is employed can dislodge the economy from the liquidity trap and ensure a return to the target equilibrium.
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Find related papers by JEL classification: E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
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Benhabib, Jess & Schmitt-Grohe, Stephanie & Uribe, Martin, 2001.
"The Perils of Taylor Rules,"
Journal of Economic Theory,
Elsevier, vol. 96(1-2), pages 40-69, January.
[Downloadable!] (restricted)
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Benhabib, Jess & Schmitt-Grohe, Stephanie & Uribe, Martin, 1998.
"The Perils of Taylor Rules,"
Working Papers
98-37, C.V. Starr Center for Applied Economics, New York University.
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Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 2002.
"Avoiding Liquidity Traps,"
Journal of Political Economy,
University of Chicago Press, vol. 110(3), pages 535-563, June.
[Downloadable!] (restricted)
Other versions:
Benhabib, J. & Schmitt-Grohe, S. & Uribe, M., 1999.
"Avoiding Liquidity Traps,"
Working Papers
99-21, C.V. Starr Center for Applied Economics, New York University.
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