Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy

50 Pages Posted: 25 Jul 2019 Last revised: 21 Oct 2019

See all articles by Taisuke Nakata

Taisuke Nakata

Board of Governors of the Federal Reserve System

Sebastian Schmidt

European Central Bank (ECB)

Multiple version iconThere are 2 versions of this paper

Date Written: 2019-07-17

Abstract

We study optimal monetary and fiscal policy in a New Keynesian model where occasional declines in agents' confidence give rise to persistent liquidity trap episodes. There is no straightforward recipe for enhancing welfare in this economy. Raising the inflation target or appointing an inflation-conservative central banker mitigates the inflation shortfall away from the lower bound but exacerbates deflationary pressures at the lower bound. Using government spending as an additional policy instrument worsens allocations at and away from the lower bound. However, appointing a policymaker who is sufficiently less concerned with government spending stabilization than society eliminates expectations-driven liquidity traps.

Keywords: Effective Lower Bound, Sunspot Equilibria, Monetary Policy, Fiscal Policy, Discretion, Policy Delegation

JEL Classification: E62, E61, E52

Suggested Citation

Nakata, Taisuke and Schmidt, Sebastian, Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy (2019-07-17). FEDS Working Paper No. 2019-053. Available at SSRN: https://ssrn.com/abstract=3423253 or http://dx.doi.org/10.17016/FEDS.2019.053

Taisuke Nakata (Contact Author)

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

Sebastian Schmidt

European Central Bank (ECB) ( email )

Sonnemannstrasse 22
Frankfurt am Main, 60314
Germany

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