The New-Keynesian Liquidity Trap
47 Pages Posted: 21 Sep 2013 Last revised: 14 Oct 2014
Date Written: October 7, 2014
In standard solutions, the new-Keynesian model produces a deep recession with deflation in a liquidity trap. The model also makes unusual policy predictions: Useless government spending, technical regress, and capital destruction have large multipliers. These predictions become larger as prices become less sticky. I show that both sets of predictions are strongly affected by equilibrium selection. For the same interest-rate path, different choices of equilibria -- either by the researcher's direct selection or the researcher's specification of expected Federal Reserve policy -- can overturn all these results. A set of "local-to-frictionless" equilibria predicts mild inflation, no output reduction and negative multipliers during the liquidity trap, and its predictions approach the frictionless model smoothly, all for the same interest rate path.
Keywords: New-Keynesian models, liquidity trap, stimulus, multiplier
JEL Classification: E3, E4, E5
Suggested Citation: Suggested Citation