Research Discussion Papers, Bank of Finland
No 22/2003:
Policy interaction, expectations and the liquidity trap
George W. Evans and Seppo Honkapohja
Abstract: In this paper we consider inflation and government debt
dynamics when monetary policy employs a global interest rate rule and
private agents’ forecasts using adaptive learning. Because of the zero
lower bound on interest rates, active interest rate rules are known to
imply the existence of a second, low inflation steady state, below the
target inflation rate. Under adaptive learning dynamics we find the
additional possibility of a liquidity trap, in which the economy slips
below this low inflation steady state and is driven to an even lower
inflation floor which, in turn, is supported by a switch to an aggressive
money supply rule. Fiscal policy alone cannot push the economy out of the
liquidity trap. However, raising the threshold at which the money supply
rule is employed can dislodge the economy from the liquidity trap and
ensure a return to the target equilibrium.
Keywords: stability of equilibria; fiscal and monetary policy; interest rate and money supply rules; (follow links to similar papers)
JEL-Codes: E52; E58; E63; (follow links to similar papers)
37 pages, September 10, 2003
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