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Fiscal Policy in an Expectations-Driven Liquidity Trap

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  • Karel R. S. M. Mertens
  • Morten O. Ravn

Abstract

We study the effects of fiscal policy interventions in a liquidity trap in a model with nominal rigidities and an interest rate rule. In a liquidity trap caused by a self-fulfilling state of low confidence, higher government spending has deflationary effects that reduce the spending multiplier when the zero lower bound is binding. Instead, cuts in marginal labour tax rates are inflationary and become more expansionary when the zero lower bound is binding. These findings contradict a popular view, based on a liquidity trap caused by a fundamental shock such as a taste shock, that higher government spending is inflationary and can therefore be associated with large multipliers at the zero lower bound, while lower marginal tax rates are deflationary and therefore counterproductive.

Suggested Citation

  • 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.
  • Handle: RePEc:oup:restud:v:81:y:2014:i:4:p:637-1667
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    File URL: http://hdl.handle.net/10.1093/restud/rdu016
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    More about this item

    JEL classification:

    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy

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