Sebastian Schmidt from ECB - Expectations-driven liquidity traps: Implications for monetary and fiscal policy

Co-author: Taisuke Nakata (University of Tokyo)

Abstract:

We study optimal time-consistent monetary and fiscal policy in a New Keynesian model where occasional declines in agents' confidence give rise to persistent liquidity trap episodes. Insights from widely-studied fundamental-driven liquidity traps are not a useful guide for enhancing welfare in this model. Raising the inflation target, appointing an inflation-conservative central banker, or allowing for the use of government spending as an additional stabilization tool can exacerbate deflationary pressures and demand deficiencies during the liquidity trap episodes. However, appointing a policymaker who is sufficiently less concerned with government spending stabilization than society eliminates expectations-driven liquidity traps.

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