Liquidity traps and expectation dynamics : fiscal stimulus or fiscal austerity?
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We examine global dynamics under infinite-horizon learning in New Keynesian models where the interest-rate rule is subject to the zero lower bound. 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 in some cases a policy of fiscal austerity, will insulate the economy from deflation traps if the policy is appropriately tailored in magnitude and duration. A fiscal stimulus "switching rule," which automatically kicks in without discretionary fine-tuning, can be equally effective.
Benhabib , J , Evans , G W & Honkapohja , S 2014 , ' Liquidity traps and expectation dynamics : fiscal stimulus or fiscal austerity? ' Journal of Economic Dynamics and Control , vol 45 , pp. 220-238 . DOI: 10.1016/j.jedc.2014.05.021
Journal of Economic Dynamics and Control
© 2014. Elsevier Inc. All rights reserved. This is the author’s version of a work that was accepted for publication in Journal of Economic Dynamics & Control. Changes resulting from the publishing process, such as peer review, editing, corrections, structural formatting, and other quality control mechanisms may not be reflected in this document. Changes may have been made to this work since it was submitted for publication. A definitive version was subsequently published in Journal of Economic Dynamics and Control, 45, August 2014 DOI http://dx.doi.org/10.1016/j.jedc.2014.05.021
Financial support from National Science Foundation Grant no. SES-1025011 is gratefully acknowledged.
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