Federal Reserve Bank of Chicago
Working Paper Series
Escaping the Great Recession
While high uncertainty is an inherent implication of the economy entering the zero lower bound, deflation is not, because agents are likely to be uncertain about the way policymakers will deal with the large stock of debt arising from a severe recession. We draw this conclusion based on a new-Keynesian model in which the monetary/fiscal policy mix can change over time and zero-lower-bound episodes are recurrent. Given that policymakers’ behavior is constrained at the zero lower bound, beliefs about the exit strategy play a key role. Announcing a period of austerity is detrimental in the short run, but it preserves macroeconomic stability in the long run. A large recession can be avoided by abandoning fiscal discipline, but this results in a sharp increase in macroeconomic instability once the economy is out of the recession. Contradictory announcements by the fiscal and monetary authorities can lead to high inflation and large output losses. The policy trade-off can be resolved by committing to inflate away only the portion of debt resulting from an unusually large recession.
Cite this item
Francesco Bianchi & Leonardo Melosi, Escaping the Great Recession, Federal Reserve Bank of Chicago, Working Paper Series WP-2014-17, 01 Aug 2014, revised 01 Jan 2014.
- D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness
- E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy
- E63 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Comparative or Joint Analysis of Fiscal and Monetary Policy; Stabilization; Treasury Policy
Keywords: Policy uncertainty; macroeconomic uncertainty; Markov-switching models; shock-specific policy rules; zero lower bound
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