Lack of Confidence, the Zero Lower Bound, and the Virtue of Fiscal Rules
17 Pages Posted: 24 Jun 2015
Date Written: June 22, 2015
In the presence of the zero lower bound, standard business cycle models with a Taylor-type monetary policy rule are prone to equilibrium multiplicity. A drop in confidence can drive the economy into a liquidity trap without any change in fundamentals. Using a prototypical sticky-price model, I show that Ricardian fiscal spending rules that prevent real marginal costs from declining in the face of a confidence shock insulate the economy from such expectations-driven liquidity traps.
Keywords: government spending; liquidity trap; multiple equilibria; Ricardian fiscal policy; sunspots
JEL Classification: E52, E62
Suggested Citation: Suggested Citation