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

54 Pages Posted: 1 Aug 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: August, 2019

Abstract

We study optimal monetary and fiscal policy in a New Keynesian model where occasional declines in agents’ confidence can give rise to persistent liquidity trap episodes. Unlike in the case of fundamental-driven liquidity traps, there is no straightforward recipe for mitigating the welfare costs and the systematic inflation shortfall associated with expectations-driven liquidity traps. Raising the inflation target or appointing an inflation-conservative central banker improves inflation outcomes away from the lower bound but exacerbates the shortfall at the lower bound. Using government spending as an additional policy tool worsens stabilization outcomes both at and away from the lower bound. However, appointing a policymaker who is sufficiently less concerned with government spending stabilization than society can eliminate expectations-driven liquidity traps altogether.

Keywords: discretion, effective lower bound, fiscal policy, monetary policy, policy delegation, sunspot equilibria

JEL Classification: E52, E61, E62

Suggested Citation

Nakata, Taisuke and Schmidt, Sebastian, Expectations-Driven Liquidity Traps: Implications for Monetary and Fiscal Policy (August, 2019). ECB Working Paper No. 2304. Available at SSRN: https://ssrn.com/abstract=3430355

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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