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Deflationary traps, agents’ beliefs and fiscal–monetary policies

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  • De Grauwe, Paul
  • Foresti, Pasquale

Abstract

We study the role of agents’ limited cognitive capabilities, combined with fiscal and monetary policies, in the generation of a deflationary trap. In order to do so, we employ a heterogeneous expectations New Keynesian model in which the agents’ forecasts are based on simple heuristics. Thanks to a learning mechanism, the model is able to generate endogenous changes in agents’ beliefs that we prove to have a crucial role in the characterization of a deflationary trap. We show that the probability of hitting the zero lower bound on the interest rate, and potentially entering a deflationary trap, is not only affected by the inflation target set by the central bank. This probability is also influenced by the governments’ focus on public debt stabilization and by the agents’ memory and willingness to learn. We also show that the impact of these factors is very significant for inflation targets in the range 0–3%, while an inflation target of 4% isolates the system from the zero lower bound problem.

Suggested Citation

  • De Grauwe, Paul & Foresti, Pasquale, 2025. "Deflationary traps, agents’ beliefs and fiscal–monetary policies," LSE Research Online Documents on Economics 127946, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:127946
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    References listed on IDEAS

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    1. George A. Akerlof, 2009. "How Human Psychology Drives the Economy and Why It Matters," American Journal of Agricultural Economics, Agricultural and Applied Economics Association, vol. 91(5), pages 1175-1175.
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    3. Albonico, Alice & Ascari, Guido & Gobbi, Alessandro, 2021. "The public debt multiplier," Journal of Economic Dynamics and Control, Elsevier, vol. 132(C).
    4. Pfajfar, Damjan & Žakelj, Blaž, 2014. "Experimental evidence on inflation expectation formation," Journal of Economic Dynamics and Control, Elsevier, vol. 44(C), pages 147-168.
    5. Jump, Robert Calvert & Levine, Paul, 2019. "Behavioural New Keynesian models," Journal of Macroeconomics, Elsevier, vol. 59(C), pages 59-77.
    6. Alice Albonico & Guido Ascari & Alessandro Gobbi, 2018. "The debt multiplier," Working Papers 396, University of Milano-Bicocca, Department of Economics, revised 20 Dec 2018.
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    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • F33 - International Economics - - International Finance - - - International Monetary Arrangements and Institutions
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration

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