Working Paper

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

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.

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

JEL Classification: E62; E61; E52;

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

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: Finance and Economics Discussion Series

Publication Date: 2019-07-17

Number: 2019-053

Pages: 50 pages