A Step Towards a Solution to the Confidence-Driven Liquidity Trap Morass

Haochun Ma and Jordan Roulleau-Pasdeloup

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Abstract: Depending on the persistence of a one-off shock bringing the economy to the Effective Lower Bound (ELB), the standard New Keynesian model predicts starkly different conclusions. We offer a potential solution to this morass by assuming that the one-off shock is such that the economy necessarily leaves the ELB in finite time. Under these assumptions, we prove that the confidence-driven liquidity trap \`a la \cite{mertens2014fiscal} doesn't arise as an equilibrium outcome and that there is a unique path back for a given steady state. Furthermore, under our shock specification the effect of government spending on consumption is necessarily positive and does not switch signs but may grow unbounded \textemdash a puzzle.

Date: 2025-11, Revised 2026-09
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