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Bank of Finland Research Discussion Papers, Bank of Finland

No 24/2009:
Expectations, deflation traps and macroeconomic policy

George W Evans and Seppo Honkapohja ()

Abstract: We examine global economic dynamics under infinite-horizon learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. As in Evans, Guse and Honkapohja, European Economic Review (2008), we find that under normal monetary and fiscal policy the intended steady state is locally but not globally stable. Unstable deflationary paths can arise after large pessimistic shocks to expectations. For large expectation shocks that push interest rates to the zero lower bound, temporary increases in government spending can effectively insulate the economy from deflation traps.

Keywords: adaptive learning; monetary policy; fiscal policy; zero interest rate lower bound; (follow links to similar papers)

JEL-Codes: E52; E58; E63; (follow links to similar papers)

35 pages, September 22, 2009

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