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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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    1. repec:eee:dyncon:v:82:y:2017:i:c:p:21-43 is not listed on IDEAS
    2. Bartholomew Moore, 2016. "The stability of learning prior to an anticipated change in the target inflation rate," International Journal of Monetary Economics and Finance, Inderscience Enterprises Ltd, vol. 9(3), pages 267-293.
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    4. Hommes, C.H. & Lustenhouwer, J., 2016. "Managing Heterogeneous and Unanchored Expectations: A Monetary Policy Analysis," CeNDEF Working Papers 16-01, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
    5. Schmidt, Sebastian, 2016. "Lack of confidence, the zero lower bound, and the virtue of fiscal rules," Journal of Economic Dynamics and Control, Elsevier, vol. 70(C), pages 36-53.
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    7. Seppo Honkapohja, 2016. "Monetary policies to counter the zero interest rate: an overview of research," Empirica, Springer;Austrian Institute for Economic Research;Austrian Economic Association, vol. 43(2), pages 235-256, May.
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    13. Hommes, C.H. & Massaro, D. & Salle, I., 2015. "Monetary and Fiscal Policy Design at the Zero Lower Bound - Evidence from the Lab," CeNDEF Working Papers 15-11, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
    14. Lansing, Kevin J., 2017. "Endogenous Regime Switching Near the Zero Lower Bound," Working Paper Series 2017-24, Federal Reserve Bank of San Francisco.
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    16. Karel R. S. M. Mertens & Morten O. Ravn, 2014. "Fiscal Policy in an Expectations-Driven Liquidity Trap," Review of Economic Studies, Oxford University Press, vol. 81(4), pages 1637-1667.
    17. Honkapohja, Seppo & Kaushik, Mitra, 2018. "Price level targeting with evolving credibility," Research Discussion Papers 5/2018, Bank of Finland.
    18. Hommes, C.H. & Lustenhouwer, J., 2015. "Inflation Targeting and Liquidity Traps under Endogenous Credibility," CeNDEF Working Papers 15-03, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
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    More about this item

    Keywords

    Adaptive learning; Monetary policy; Fiscal policy; Zero interest rate lower bound;

    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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