Finance and Economics Discussion Series (FEDS)

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July 2019

Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy

Taisuke Nakata and Sebastian Schmidt

Abstract:

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.
Accessible materials (.zip)

Keywords: Discretion, Effective Lower Bound, Fiscal policy, Monetary policy, Policy Delegation, Sunspot Equilibria

DOI: https://doi.org/10.17016/FEDS.2019.053

PDF: Full Paper

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Last Update: January 09, 2020