Optimal Conventional Stabilization Policy in a Liquidity Trap When Wages and Prices are Sticky

Adiya Belgibayeva and Michal Horvath

Discussion Papers from Department of Economics, University of York

Abstract: We study an economy in a liquidity trap in which wage adjustment is staggered. In this economy, it is optimal not to use expected inflation as a stabilization tool in or out of the liquidity trap. In such a world, the well-known conventional stabilization mix should be applied more forcefully: the forward commitment regarding interest rates should apply for even longer, and government spending should `lean against the wind' more vigorously. This policy strategy generates a real economy boom in the future and helps stabilizing demand in the short run. Tax policy plays a key role in ensuring price stability. This is generally consistent with a short-run income tax hike counteracting deflationary pressures. The initial government spending expansion is thus close to a balanced-budget one.

Keywords: Zero Lower Bound; Sticky Wages; Inflation Stabilization; Income Tax; Government Spending. (search for similar items in EconPapers)
JEL-codes: E31 E32 E52 E61 E62 (search for similar items in EconPapers)
Date: 2015-07
New Economics Papers: this item is included in nep-cba, nep-mac and nep-pbe
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Persistent link: https://EconPapers.repec.org/RePEc:yor:yorken:15/11

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