Policy interaction, expectations and the liquidity trap

George William Evans () and Seppo Mikko Sakari Honkapohja ()

No 22/2003, Research Discussion Papers from Bank of Finland

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 (search for similar items in EconPapers)
JEL-codes: E52 E58 E63 (search for similar items in EconPapers)
Date: Written
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Related works:
Working Paper: Policy interaction, expectations, and the liquidity trap (2003)
Working Paper: Policy Interaction, Expectations and the Liquidity Trap (2004)
Working Paper: Policy interaction, expectations and the liquidity trap (2004)
Journal Article: Policy Interaction, Expectations and the Liquidity Trap (2005)
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Persistent link: http://EconPapers.repec.org/RePEc:hhs:bofrdp:2003_022

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