Escaping the Great Recession

Francesco Bianchi and Leonardo Melosi

No 13-19, Working Papers from Duke University, Department of Economics

Abstract: While high uncertainty is an inherent implication of the economy entering the zero lower bound, deflation is not, because agents are likely to be uncertain about the way policymakers will deal with the large stock of debt arising from a severe recession. We draw this conclusion based on a new-Keynesian model in which the monetary/fiscal policy mix can change over time and zero-lower-bound episodes are recurrent. Given that policymakers’ behavior is constrained at the zero lower bound, beliefs about the exit strategy play a key role. Announcing a period of austerity is detrimental in the short run, but it preserves macroeconomic stability in the long run. A large recession can be avoided by abandoning fiscal discipline, but this results in a sharp increase in macroeconomic instability once the economy is out of the recession. Contradictory announcements by the fiscal and monetary authorities can lead to high inflation and large output losses. The policy trade-off can be resolved by committing to inflate away only the portion of debt resulting from an unusually large recession.

Keywords: Monetary and fiscal policy interaction; Markov-switching DSGE models; uncertainty; shock-specific policy rules; zero lower bound (search for similar items in EconPapers)
JEL-codes: D83 E31 E52 E62 E63 (search for similar items in EconPapers)
Pages: 43
Date: 2013
New Economics Papers: this item is included in nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Related works:
Journal Article: Escaping the Great Recession (2017)
Working Paper: Escaping the Great Recession (2016)
Working Paper: Escaping the Great recession (2015)
Working Paper: Escaping the Great Recession (2014)
Working Paper: Escaping the Great Recession (2014)
Working Paper: Escaping the Great Recession (2013)
Working Paper: Escaping the Great Recession (2013)
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