Lack of Confidence, the Zero Lower Bound, and the Virtue of Fiscal Rules

17 Pages Posted: 24 Jun 2015

Date Written: June 22, 2015

Abstract

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

Schmidt, Sebastian, Lack of Confidence, the Zero Lower Bound, and the Virtue of Fiscal Rules (June 22, 2015). ECB Working Paper No. 1795. Available at SSRN: https://ssrn.com/abstract=2621523

Sebastian Schmidt (Contact Author)

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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