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Policy interaction, expectations and the liquidity trap

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Author Info

  • George W. Evans

    (Department of Economics, University of Oregon)

  • Seppo Honkapohja

    (Department of Economics, University of Helsinki, Finland)

Abstract

In this paper we consider inflation and government debt dynamics when monetary policy employs a global interest rate rule and private agents’ forecasts 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 which, in turn, 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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Bibliographic Info

Paper provided by EconWPA in its series Macroeconomics with number 0404033.

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Date of creation: 28 Apr 2004
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Handle: RePEc:wpa:wuwpma:0404033

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Related research

Keywords: stability of equilibria; fiscal and monetary policy; interest rate and money supply rules;

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  1. Jess Benhabib & Stephanie Schmitt-Grohe & Martin Uribe, 1998. "The perils of Taylor Rules," Departmental Working Papers 199831, Rutgers University, Department of Economics.
  2. Bullard, James & Cho, In-Koo, 2005. "Escapist policy rules," Journal of Economic Dynamics and Control, Elsevier, vol. 29(11), pages 1841-1865, November.
  3. 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.
  4. 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.
  5. N. Williams, 2002. "Stability and Long Run Equilibrium in Stochastic Fictitious Play," Princeton Economic Theory Working Papers cbeeeb49cc8afc83f125df5a8, David K. Levine.
  6. Thomas Sargent & Noah Williams & Tao Zha, 2006. "The conquest of South American inflation," Working Paper 2006-20, Federal Reserve Bank of Atlanta.
  7. In-Koo Cho & Kenneth Kasa, 2003. "Learning Dynamics and Endogenous Currency Crises," Computing in Economics and Finance 2003 132, Society for Computational Economics.
  8. In-Koo Cho & Thomas J. Sargent, 2000. "Escaping Nash inflation," Working Paper Series 23, European Central Bank.
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  1. > Macroeconomics > Monetary Theory
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