Fiscal Policy in an Expectations Driven Liquidity Trap

Morten Ravn and Karel Mertens

No 7931, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We examine the impact of fiscal policy interventions in an environment where the short term nominal interest rate is at the zero bound. In the basic New Keynesian model in which the monetary authority operates a Taylor rule, globally multiple equilibria arise, some of which display all the features of a liquidity trap. A loss in confidence can set the economy on a deflationary path that eventually prevents the monetary authority from adjusting the interest rate and can lead to potentially very large output drops. Contrary to a line of recent papers, we find that demand stimulating policies become less effective in a liquidity trap than in normal circumstances. The key reason is that demand stimulus leads agents to believe that things are even worse than they thought. In contrast, supply side policies, such as cuts in labor income taxes, lead to relative optimism and become more powerful.

Keywords: Confidence shocks; Fiscal policy; Liquidity trap; Sunspots (search for similar items in EconPapers)
JEL-codes: E30 E50 E62 (search for similar items in EconPapers)
Date: 2010-07
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Citations: View citations in EconPapers (102)

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Journal Article: Fiscal Policy in an Expectations-Driven Liquidity Trap (2014)
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