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Liquidity traps and expectation dynamics: Fiscal stimulus or fiscal austerity?

  • Benhabib , Jess

    (New York University)

  • Evans, George W.

    (University of Oregon, University of St. Andrews)

  • Honkapohja, Seppo

    ()

    (Bank of Finland)

We examine global dynamics under infinite-horizon learning in New Keynesian models where the interest-rate rule is subject to the zero lower bound. As in Evans, Guse and Honkapohja (2008), 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 a policy of fiscal austerity, appropriately tailored in magnitude and duration, will insulate the economy from deflation traps. However “fiscal switching rules” that automatically kick in without discretionary fine tuning can be equally effective.

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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/BoF_DP_1227.pdf
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Paper provided by Bank of Finland in its series Research Discussion Papers with number 27/2012.

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Length: 33 pages
Date of creation: 09 Oct 2012
Date of revision:
Handle: RePEc:hhs:bofrdp:2012_027
Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/

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