Research Discussion Papers, Bank of Finland
Jess Benhabib, George W. Evans and Seppo Honkapohja
Liquidity traps and expectation dynamics: Fiscal stimulus or fiscal austerity?
Abstract: We examine global dynamics under infinite-horizon learning
in New Keynesian models where the interest-rate rule is subject to the zero
lower bound. As in Evans, Guse and Honkapohja (2008), the intended steady
state is locally but not globally stable. Unstable deflationary paths
emerge after large pessimistic shocks to expectations. For large
expectation shocks that push interest rates to the zero bound, a temporary
fiscal stimulus or a policy of fiscal austerity, appropriately tailored in
magnitude and duration, will insulate the economy from deflation traps.
However “fiscal switching rules” that automatically kick in without
discretionary fine tuning can be equally effective.
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)
33 pages, October 9, 2012
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