Monetary and fiscal policy under learning in the presence of a liquidity trap
Institute for Monetary and Economic Studies, Bank of Japan, 2007 - Business & Economics - 31 pages
This paper reports on the findings of Evans, Guse and Honkapohja (2007) concerning the global economic dynamics under learning in a New Keynesian model in which the interest-rate rule is subject to the zero lower bound. Under normal monetary and fiscal policy the intended steady state is locally but not globally stable. Large pessimistic shocks to expectations can lead to deflationary spirals with falling prices and falling output. To avoid this outcome we recommend augmenting normal policies with inflation threshold policies: if under normal policies inflation would fall below a suitably chosen threshold, these policies should be replaced by aggressive monetary and fiscal policies that guarantee this lower bound on inflation.--Author's description.
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aggressive fiscal policy aggressive monetary policy aggressive policies analysis augmented Benhabib bounded rationality coefficient constant gain consumption convergence deflation E-stability economy Eggertsson and Woodford ensure Euler equations Evans and Honkapohja exogenous shocks expectation shocks Figure Fisher equation flexible-price forecasts global government spending Guse Honkapohja 2007 inflation falls inflation rate inflation target inflation threshold 7r inflation threshold policies intended steady interest-rate rule Law of Motion lead learning dynamics linearized liquidity traps locally stable low-inflation steady lump-sum taxes monetary and fiscal nominal interest rate normal monetary normal policy output threshold parameters Perceived Law perfect foresight pessimistic expectations Phillips Curve possibility of deflationary price stickiness private agents rational expectations recommended policy saddle point Schmitt-Grohe shock to expectations stable under learning steady state 7r steady state n steady state ttl steady-state sufficiently targeted steady Taylor rule temporary equilibrium triggers aggressive monetary unstable Uribe values variables zero lower bound