Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy
50 Pages Posted: 25 Jul 2019 Last revised: 21 Oct 2019
Date Written: July, 2019
We study optimal monetary and fiscal policy in a New Keynesian model where occasional declines in agents' confidence give rise to persistent liquidity trap episodes. There is no straightforward recipe for enhancing welfare in this economy. Raising the inflation target or appointing an inflation-conservative central banker mitigates the inflation shortfall away from the lower bound but exacerbates deflationary pressures at the lower bound. Using government spending as an additional policy instrument worsens allocations at and away from the lower bound. However, appointing a policymaker who is sufficiently less concerned with government spending stabilization than society eliminates expectations-driven liquidity traps.
JEL Classification: E62, E61, E52
Suggested Citation: Suggested Citation