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Title: Liquidity Traps and Expectation Dynamics: Fiscal Stimulus or Fiscal Austerity?

Author(s): Jess Benhabib, George W. Evans and Seppo Honkapohja

Publication Date: October 2012

Keyword(s): adaptive learning, fiscal policy, monetary policy and zero interest rate lower bound

Programme Area(s): International Macroeconomics

Abstract: We examine global dynamics under infinite-horizon learning in New Keynesian models where the interest-rate rule is subject to the zero lower bound. As in Evans, Guse and Honkapohja (2008), the intended steady state is locally but not globally stable. Unstable deflationary paths emerge after large pessimistic shocks to expectations. For large expectation shocks that push interest rates to the zero bound, a temporary fiscal stimulus or a policy of fiscal austerity, appropriately tailored in magnitude and duration, will insulate the economy from deflation traps. However "fiscal switching rules" that automatically kick in without discretionary fine tuning can be equally effective.

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Bibliographic Reference

Benhabib, J, Evans, G and Honkapohja, S. 2012. 'Liquidity Traps and Expectation Dynamics: Fiscal Stimulus or Fiscal Austerity?'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=9176