Liquidity Traps and Expectation Dynamics: Fiscal Stimulus or Fiscal Austerity?

37 Pages Posted: 10 Nov 2012

See all articles by Jess Benhabib

Jess Benhabib

New York University - Leonard N. Stern School of Business - Department of Economics; National Bureau of Economic Research (NBER)

George W. Evans

University of Oregon - Department of Economics; University of St. Andrews - School of Economics and Finance

Seppo Honkapohja

Centre for Economic Policy Research (CEPR); Aalto University School of Business; CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Aalto University - School of Business

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Date Written: October 9, 2012

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. As in Evans, Guse and Honkapohja (2008), 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 a policy of fiscal austerity, appropriately tailored in magnitude and duration, will insulate the economy from deflation traps. However “fiscal switching rules” that automatically kick in without discretionary fine tuning can be equally effective.

Keywords: adaptive learning, monetary policy, fiscal policy, zero interest rate lower bound

JEL Classification: E63, E52, E58

Suggested Citation

Benhabib, Jess and Evans, George W. and Honkapohja, Seppo and Honkapohja, Seppo, Liquidity Traps and Expectation Dynamics: Fiscal Stimulus or Fiscal Austerity? (October 9, 2012). Bank of Finland Research Discussion Paper No. 27/2012, Available at SSRN: https://ssrn.com/abstract=2173147 or http://dx.doi.org/10.2139/ssrn.2173147

Jess Benhabib

New York University - Leonard N. Stern School of Business - Department of Economics ( email )

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George W. Evans

University of Oregon - Department of Economics ( email )

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University of St. Andrews - School of Economics and Finance ( email )

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United Kingdom
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HOME PAGE: http://www.st-andrews.ac.uk/economics/staff/pages.g.evans.shtml

Seppo Honkapohja (Contact Author)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Aalto University School of Business ( email )

, PO Box 21210
Aalto FI-00076
Finland

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

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Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Aalto University - School of Business

Finland

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