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Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy

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  • Taisuke Nakata
  • Sebastian Schmidt

Abstract

We study optimal monetary and fiscal policy in a New Keynesian model where occasional declines in agents' confidence give rise to persistent liquidity trap episodes. There is no straightforward recipe for enhancing welfare in this economy. Raising the inflation target or appointing an inflation-conservative central banker mitigates the inflation shortfall away from the lower bound but exacerbates deflationary pressures at the lower bound. Using government spending as an additional policy instrument worsens allocations at and away from the lower bound. However, appointing a policymaker who is sufficiently less concerned with government spending stabilization than society eliminates expectations-driven liquidity traps.

Suggested Citation

  • Taisuke Nakata & Sebastian Schmidt, 2019. "Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy," Finance and Economics Discussion Series 2019-053, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgfe:2019-53
    DOI: 10.17016/FEDS.2019.053
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    Cited by:

    1. Alessandro Piergallini, 2024. "Fiscal Stimulus of Last Resort," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 56(6), pages 1479-1514, September.
    2. Billi, Roberto & Galí, Jordi & Nakov, Anton, 2024. "Optimal monetary policy with r∗<0," Journal of Monetary Economics, Elsevier, vol. 142(C).
    3. Kollmann, Robert, 2021. "Liquidity traps in a world economy," Journal of Economic Dynamics and Control, Elsevier, vol. 132(C).
    4. Tom D. Holden, 2024. "Robust Real Rate Rules," Econometrica, Econometric Society, vol. 92(5), pages 1521-1551, September.
    5. Ascari, Guido & Mavroeidis, Sophocles, 2022. "The unbearable lightness of equilibria in a low interest rate environment," Journal of Monetary Economics, Elsevier, vol. 127(C), pages 1-17.
    6. Hills, Timothy S. & Nakata, Taisuke & Schmidt, Sebastian, 2019. "Effective lower bound risk," European Economic Review, Elsevier, vol. 120(C).
    7. Piergallini, Alessandro, 2022. "Average inflation targeting and macroeconomic stability," Economics Letters, Elsevier, vol. 219(C).
    8. Nicolas Caramp & Sanjay R Singh, 2023. "Bond Premium Cyclicality and Liquidity Traps," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 90(6), pages 2822-2879.
    9. Yoichiro Tamanyu, 2020. "The Role of Nonlinearity in Indeterminate Models: An Application to Expectations-Driven Liquidity Traps," Keio-IES Discussion Paper Series 2020-023, Institute for Economics Studies, Keio University.
    10. Ryan Banerjee & Aaron Mehrotra, 2023. "Unanticipated and Backward-Looking: Deflations and the Behavior of Inflation Expectations," International Journal of Central Banking, International Journal of Central Banking, vol. 19(4), pages 41-83, October.
    11. Ascari, Guido & Mavroeidis, Sophocles & McClung, Nigel, 2023. "Coherence without rationality at the zero lower bound," Journal of Economic Theory, Elsevier, vol. 214(C).
    12. Chunbing Cai & Jordan Roulleau-Pasdeloup, 2023. "Simple Analytics of the Government Investment Multiplier," Papers 2302.11212, arXiv.org, revised Sep 2023.

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    More about this item

    Keywords

    Effective Lower Bound; Sunspot Equilibria; Monetary Policy; Fiscal Policy; Discretion; Policy Delegation;
    All these keywords.

    JEL classification:

    • E62 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Fiscal Policy; Modern Monetary Theory
    • E61 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook - - - Policy Objectives; Policy Designs and Consistency; Policy Coordination
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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