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Government Debt and Expectations-Driven Liquidity Traps

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  • Charles de Beauffort

    (National Bank of Belgium)

Abstract

The presence of an effective lower bound on the nominal interest rate creates a risk that expectations of low inflation become entrenched. When this happens, distortionary taxation and expansionary fiscal policies may result in a large accumulation of debt that spurs inflation when the lower bound ceases to bind. The corresponding increase in expected real interest rates then further depresses consumption and output. In light of this outcome, the welfare-maximizing strategy in an expectations-driven liquidity trap is to downsize the government by concurrently cutting taxes and spending. This policy achieves the twin objective of stimulating the economy while containing the debt accumulation.

Suggested Citation

  • Charles de Beauffort, 2024. "Government Debt and Expectations-Driven Liquidity Traps," International Journal of Central Banking, International Journal of Central Banking, vol. 20(4), pages 321-370, October.
    • Handle: RePEc:ijc:ijcjou:y:2024:q:4:a:6
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    References listed on IDEAS

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    1. Burgert, Matthias & Schmidt, Sebastian, 2014. "Dealing with a liquidity trap when government debt matters: Optimal time-consistent monetary and fiscal policy," Journal of Economic Dynamics and Control, Elsevier, vol. 47(C), pages 282-299.
    2. S Borağan Aruoba & Pablo Cuba-Borda & Frank Schorfheide, 2018. "Macroeconomic Dynamics Near the ZLB: A Tale of Two Countries," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 85(1), pages 87-118.
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