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Fiscal stimulus in expectations-driven liquidity traps

Joep Lustenhouwer

Journal of Economic Behavior & Organization, 2020, vol. 177, issue C, 661-687

Abstract: I study liquidity traps in a model where agents have heterogeneous expectations and finite planning horizons. Backward-looking agents base their expectations on past observations, while forward-looking agents have fully rational expectations. Liquidity traps that are fully or partly driven by expectations can arise due to pessimism of backward-looking agents. Only when planning horizons are finite, these liquidity traps can be of longer duration without ending up in a deflationary spiral. I further find that fiscal stimulus in the form of an increase in government spending or a cut in consumption taxes can be very effective in mitigating the liquidity trap. A feedback mechanism of heterogeneous expectations causes fiscal multipliers to be the largest when the majority of agents are backward-looking but there also is a considerable fraction of agents that are forward-looking. Labor tax cuts are always deflationary and are not an effective tool in a liquidity trap.

Keywords: Bounded rationality; Fiscal policy; Liquidity trap; Heterogeneous expectations (search for similar items in EconPapers)
Date: 2020
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jeborg:v:177:y:2020:i:c:p:661-687

DOI: 10.1016/j.jebo.2020.07.003

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Journal of Economic Behavior & Organization is currently edited by Houser, D. and Puzzello, D.

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