Liquidity traps and expectation dynamics: Fiscal stimulus or fiscal austerity?

Jess Benhabib, George W. Evans, Seppo Honkapohja

    Research output: Contribution to journalArticle

    Abstract

    We examine global dynamics under infinite-horizon learning in New Keynesian models where the interest-rate rule is subject to the zero lower bound. The intended steady state is locally but not globally stable. Unstable deflationary paths emerge after large pessimistic shocks to expectations. For large expectation shocks that push interest rates to the zero bound, a temporary fiscal stimulus, or in some cases a policy of fiscal austerity, will insulate the economy from deflation traps if the policy is appropriately tailored in magnitude and duration. A fiscal stimulus "switching rule," which automatically kicks in without discretionary fine-tuning, can be equally effective.

    Original languageEnglish (US)
    Pages (from-to)220-238
    Number of pages19
    JournalJournal of Economic Dynamics and Control
    Volume45
    DOIs
    StatePublished - Aug 2014

    Keywords

    • Adaptive learning
    • Fiscal policy
    • Monetary policy
    • Zero interest rate lower bound

    ASJC Scopus subject areas

    • Economics and Econometrics
    • Control and Optimization
    • Applied Mathematics

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