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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. 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 in some cases a policy of fiscal austerity, will insulate the economy from deflation traps if the policy is appropriately tailored in magnitude and duration. A fiscal stimulus “switching rule,” which automatically kicks in without discretionary fine-tuning, can be equally effective.

Suggested Citation

  • Benhabib, Jess & Evans, George W. & Honkapohja, Seppo, 2014. "Liquidity traps and expectation dynamics: Fiscal stimulus or fiscal austerity?," Journal of Economic Dynamics and Control, Elsevier, vol. 45(C), pages 220-238.
  • Handle: RePEc:eee:dyncon:v:45:y:2014:i:c:p:220-238
    DOI: 10.1016/j.jedc.2014.05.021
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    More about this item

    Keywords

    Adaptive learning; Monetary policy; Fiscal policy; Zero interest rate lower bound;
    All these keywords.

    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; Treasury Policy
    • 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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