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Optimal Conventional Stabilization Policy in a Liquidity Trap When Wages and Prices are Sticky

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  • Adiya Belgibayeva
  • Michal Horvath

Abstract

We study an economy in a liquidity trap in which wage adjustment is staggered. In this economy, it is optimal not to use expected inflation as a stabilization tool in or out of the liquidity trap. In such a world, the well-known conventional stabilization mix should be applied more forcefully: the forward commitment regarding interest rates should apply for even longer, and government spending should `lean against the wind' more vigorously. This policy strategy generates a real economy boom in the future and helps stabilizing demand in the short run. Tax policy plays a key role in ensuring price stability. This is generally consistent with a short-run income tax hike counteracting deflationary pressures. The initial government spending expansion is thus close to a balanced-budget one.

Suggested Citation

  • Adiya Belgibayeva & Michal Horvath, 2015. "Optimal Conventional Stabilization Policy in a Liquidity Trap When Wages and Prices are Sticky," Discussion Papers 15/11, Department of Economics, University of York.
    • Handle: RePEc:yor:yorken:15/11
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    References listed on IDEAS

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    Keywords

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    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • 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
    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory

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