DP11428 Expectations, Stagnation and Fiscal Policy

Author(s): George W. Evans, Seppo Honkapohja, Kaushik Mitra
Publication Date: August 2016
Keyword(s): Adaptive Learning, Deflation, Expectations, Fiscal policy, New Keynesian Model, Output Multiplier, Stagnation
JEL(s): D84, E21, E43, E62
Programme Areas: Monetary Economics and Fluctuations
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=11428

Stagnation as the new norm and fiscal policy are examined in a New Keynesian model with adaptive learning determining expectations. We impose inflation and consumption lower bounds, which can be relevant when agents are pessimistic. The inflation target is locally stable under learning. Pessimistic initial expectations may sink the economy into steady-state stagnation with deflation. The deflation rate can be near zero for discount factors near one or if credit frictions are present. Following a severe pessimistic expectations shock a large temporary fiscal stimulus is needed to avoid or emerge from stagnation. A modest stimulus is sufficient if implemented early.