Policy Effects in a Simple Fully Non-Linear New Keynesian Model of the Liquidity Trap

Abstract

We analyze a simple yet fully non-linear New Keynesian model of the liquidity trap. Productivity shocks are the only source of aggregate fluctuations and the central bank acts as a discretionary policy maker that pursues an inflation targeting strategy. We use this model to assess the effects of fiscal policy in a liquidity trap, the consequences of a commitment to change government expenditures in the future as well as the implications of lower taxes on labor and a higher inflation target. In contrast with some previous papers, we find that the effects of fiscal policy in a liquidity trap are moderate and that reductions in labor income taxes are expansionary. We do not find support for higher inflation targets.

Keywords: zero lower bound, fiscal multiplier, liquidity trap, new Keynesian model, multiple equilibria, inflation target

JEL Classification: E52, E58, E62