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Board of Governors of the Federal Reserve System (US)
Finance and Economics Discussion Series
Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy
Taisuke Nakata
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.


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Taisuke Nakata & Sebastian Schmidt, Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy, Board of Governors of the Federal Reserve System (US), Finance and Economics Discussion Series 2019-053, 17 Jul 2019.
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Keywords: Effective Lower Bound ; Sunspot Equilibria ; Monetary Policy ; Fiscal Policy ; Discretion ; Policy Delegation
DOI: 10.17016/FEDS.2019.053
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